[House Hearing, 107 Congress]
[From the U.S. Government Publishing Office]
THE FINANCIAL ACCOUNTING STANDARDS BOARD ACT
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
COMMERCE, TRADE, AND CONSUMER PROTECTION
of the
COMMITTEE ON ENERGY AND COMMERCE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SEVENTH CONGRESS
SECOND SESSION
__________
JUNE 26, 2002
__________
Serial No. 107-109
__________
Printed for the use of the Committee on Energy and Commerce
Available via the World Wide Web: http://www.access.gpo.gov/congress/
house
__________
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80-682 WASHINGTON : 2002
___________________________________________________________________________
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COMMITTEE ON ENERGY AND COMMERCE
W.J. ``BILLY'' TAUZIN, Louisiana, Chairman
MICHAEL BILIRAKIS, Florida JOHN D. DINGELL, Michigan
JOE BARTON, Texas HENRY A. WAXMAN, California
FRED UPTON, Michigan EDWARD J. MARKEY, Massachusetts
CLIFF STEARNS, Florida RALPH M. HALL, Texas
PAUL E. GILLMOR, Ohio RICK BOUCHER, Virginia
JAMES C. GREENWOOD, Pennsylvania EDOLPHUS TOWNS, New York
CHRISTOPHER COX, California FRANK PALLONE, Jr., New Jersey
NATHAN DEAL, Georgia SHERROD BROWN, Ohio
RICHARD BURR, North Carolina BART GORDON, Tennessee
ED WHITFIELD, Kentucky PETER DEUTSCH, Florida
GREG GANSKE, Iowa BOBBY L. RUSH, Illinois
CHARLIE NORWOOD, Georgia ANNA G. ESHOO, California
BARBARA CUBIN, Wyoming BART STUPAK, Michigan
JOHN SHIMKUS, Illinois ELIOT L. ENGEL, New York
HEATHER WILSON, New Mexico TOM SAWYER, Ohio
JOHN B. SHADEGG, Arizona ALBERT R. WYNN, Maryland
CHARLES ``CHIP'' PICKERING, GENE GREEN, Texas
Mississippi KAREN McCARTHY, Missouri
VITO FOSSELLA, New York TED STRICKLAND, Ohio
ROY BLUNT, Missouri DIANA DeGETTE, Colorado
TOM DAVIS, Virginia THOMAS M. BARRETT, Wisconsin
ED BRYANT, Tennessee BILL LUTHER, Minnesota
ROBERT L. EHRLICH, Jr., Maryland LOIS CAPPS, California
STEVE BUYER, Indiana MICHAEL F. DOYLE, Pennsylvania
GEORGE RADANOVICH, California CHRISTOPHER JOHN, Louisiana
CHARLES F. BASS, New Hampshire JANE HARMAN, California
JOSEPH R. PITTS, Pennsylvania
MARY BONO, California
GREG WALDEN, Oregon
LEE TERRY, Nebraska
ERNIE FLETCHER, Kentucky
David V. Marventano, Staff Director
James D. Barnette, General Counsel
Reid P.F. Stuntz, Minority Staff Director and Chief Counsel
______
Subcommittee on Commerce, Trade, and Consumer Protection
CLIFF STEARNS, Florida, Chairman
FRED UPTON, Michigan EDOLPHUS TOWNS, New York
NATHAN DEAL, Georgia DIANA DeGETTE, Colorado
Vice Chairman LOIS CAPPS, California
ED WHITFIELD, Kentucky MICHAEL F. DOYLE, Pennsylvania
BARBARA CUBIN, Wyoming CHRISTOPHER JOHN, Louisiana
JOHN SHIMKUS, Illinois JANE HARMAN, California
JOHN B. SHADEGG, Arizona HENRY A. WAXMAN, California
ED BRYANT, Tennessee EDWARD J. MARKEY, Massachusetts
GEORGE RADANOVICH, California BART GORDON, Tennessee
CHARLES F. BASS, New Hampshire PETER DEUTSCH, Florida
JOSEPH R. PITTS, Pennsylvania BOBBY L. RUSH, Illinois
MARY BONO, California ANNA G. ESHOO, California
GREG WALDEN, Oregon JOHN D. DINGELL, Michigan,
LEE TERRY, Nebraska (Ex Officio)
ERNIE FLETCHER, Kentucky
W.J. ``BILLY'' TAUZIN, Louisiana
(Ex Officio)
(ii)
C O N T E N T S
__________
Page
Testimony of:
Coffee, John C., Jr., Adolf A. Berle Professor of Law,
Columbia University Law School............................. 46
Dharan, Bala G., CPA, J. Howard Creekmore Professor of
Management, Jesse H. Jones Graduate School of Management,
Rice University............................................ 38
Jenkins, Edmund L., Chairman, Financial Accounting Standards
Board...................................................... 28
Lev, Baruch, Philips Bardes Professor of Accounting and
Finance, Department of Accounting Taxation and Business Law
& Department of Finance, Director, Vincent C. Ross
Institute of Accounting Research, Stern School of Business,
NYU........................................................ 54
Regan, Ned, President, Baruch College........................ 57
(iii)
THE FINANCIAL ACCOUNTING STANDARDS BOARD ACT
----------
WEDNESDAY, JUNE 26, 2002
House of Representatives,
Committee on Energy and Commerce,
Subcommittee on Commerce, Trade,
and Consumer Protection,
Washington, DC.
The subcommittee met, pursuant to notice, at 10 a.m., in
room 2123, Rayburn House Office Building, Hon. Cliff Stearns
(chairman) presiding.
Members present: Representatives Stearns, Upton, Shimkus,
Bryant, Bass, Fletcher, Tauzin (ex officio), Towns, Markey,
Eshoo, and Dingell (ex officio).
Also present: Representatives Gillmor, Greenwood, and
Luther.
Staff present: Brian McCullough, majority counsel; David
Cavicke, majority counsel; Ramsen Betfarhad, policy coordinator
and majority counsel; Shannon Vildostegui, majority counsel;
Will Carty, legislative clerk; and Consuela Washington,
minority counsel.
Mr. Stearns. Good morning, everybody. The Subcommittee on
Commerce, Trade, and Consumer Protection will come to order.
I want to thank personally all the distinguished witnesses
for appearing before the subcommittee this morning. Of course
all of us look forward to your testimony.
The leading headlines in the financial press no longer
speak of the latest and greatest IPO offering, nor are the
daily record highs achieved in the leading stock markets.
Instead, my colleagues, we are confronted with a seemingly
endless stream of bad financial news about companies, big and
small, that have manipulated the public financial disclosures
in their favor to the detriment of the American investor.
``Cooking the books'' is not new in America's history, but
the fact that major corporations engaged in such activity, and
that no one within or outside of government raised red flags
when it mattered, concerns us deeply.
I am a believer in the free market system. But in order for
such markets to work, they must be free of deceit and fraud.
We cannot legislate to prevent individuals from ignoring
rules and committing fraud. Those who are intent on doing so
will violate the rules. But what concerns me, and I suspect
many of my colleagues today, is that companies can comply fully
with accounting rules and standards and yet completely distort
their financial performance.
And yet another company, WorldCom, restates its earnings
for 2001 by some $3.8 billion due to accounting irregularities.
Enron did so last year to the tune of $1.2 billion. In the
committee's investigation of Enron, we learned that several of
the items that were restated were the results of mistakes that
violated existing accounting standards on consolidation of
special purpose entities.
We received testimony in our hearing in February, the SPE
served an important and valid purpose. Yet Enron's restatement
exposed the reality that enormous amounts of financial
obligations and debt of a company can be removed from the
balance sheet and hidden from its investors through SPE's under
current accounting standards.
We also discovered companies can use, and in some cases
bend, the existing financial accounting rules to give the
appearance of rapid revenue growth. Revenue recognition has
been a controversial issue for many years. But the degree to
which similar transactions can produce vastly different results
according to the manner in which they are accounted for can
defy logic.
I understand that a model of, ``one size fits all,'' is not
always appropriate or accurate. But the problem of
inconsistency appears to be pervasive enough to warrant a
serious and timely examination. I emphasize timely, as a
Financial Accounting Standards Board, FASB, has been
considering the revenue recognition issue for 26 years. In my
view, 26 years is too long of a time to spend on anything
except, of course, raising your children.
It is no coincidence that investor confidence in both the
markets and the financial statements of the companies is very
low, admits to such uncertainty.
Until we can iron the wrinkles out of the current
accounting system, investors will remain hesitant to invest,
and companies will struggle to access needed capital.
A number of post-Enron reforms are working their way
through Congress. Administrative agencies, self regulatory
organizations and board rooms in most are a welcome
improvement.
This subcommittee's jurisdiction is over accounting
standards and the setting of those standards. In the draft
legislation being considered today, while we do not address the
enforcement of accounting rules, we have included certain
underlying principles that must guide the promulgation of
accounting standards and with which all specific accounting
rules must be consistent.
These principles, we believe, are responsive to the
inherent problems with today's rule-based system of accounting
standards that many witnesses spoke to in our hearings in
February.
It is our intent that adherence to those principles will
bring about greater transparency in and understandability of
companies' financial reports, diminishing opportunities for the
obfuscation of financial facts through manipulation of
accounting standards.
Our goal with the draft legislation is to improve the
financial accounting system. It takes a very measured approach
to addressing issues that are of utmost importance to the long
term health of our economy.
The draft legislation primarily does three things. One, it
gives FASB standards Federal recognition.
Two, requires FASB to promulgate a rule requiring
accountants to apply all FASB standards consistently with the
fundamental principles of transparency and understandability.
Three, directs FASB to promulgate rules in areas where
current standards need improvements, specifically off-balance
sheet accounting, revenue recognition, and market-to-market
accounting.
One issue that is not addressed in the draft, but I wish to
have witnesses comment on, is, ``funding independence for
FASB.'' I seek unanimous consent to enter into the record a
letter by Paul Volker to me, where he states that, ``it would
be useful to find the means for more assured financing in
future years for both FASB and IASB, the International
Accounting Standards Board, free from threats of withholding
funds as a result of either businesses or political
pressures.''
By unanimous consent, I will put his letter in the record.
[The letter follows:]
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Mr. Stearns. My colleagues, although radical reforms could
have gained wide support a few months ago in the heat of the
Enron investigation, we have chosen to add value where it is
appropriate and recognize the positive characteristics of the
current system.
FASB is a private sector standard setter and has performed
well, given the enormity of its responsibilities. That said, I
wish to personally thank Mr. Jenkins, the Chairman of the
Financial Accounting Standards Board, for his service and his
willingness to participate today.
For those who may not be aware, Mr. Jenkins' term as
Chairman ends this week. He is gracious enough to accommodate
us one last time, and for that, I am grateful.
Mr. Jenkins has elevated the dialog with Congress to a
level that previously, in my opinion, did not exist. So I
welcome the witnesses today and I look forward to hearing their
comments.
And with that the distinguished ranking member of the
subcommittee, Mr. Towns.
Mr. Towns. Thank you very much, Mr. Chairman. Let me thank
you also for holding this hearing.
Corporate fraud and accounting scandals have rocked
investor confidence in our capital markets and tarnished
reputations in board rooms, accounting firms, and on Wall
Street.
The markets have sputtered along as headlines make clear
abuses thought to be unique to Enron are more widespread.
This committee conducted a bipartisan investigation into
the Enron scandal and identified three important areas of
reform: No. 1, corporate governance, accounting governance and
accounting standards.
As far as corporate governance is concerned, the New York
Stock Exchange stepped up to the plate with significant changes
to its listing requirements.
The House recently passed a bill addressing some of the
accounting governance issues. I think we will see more reform
in this area when this issue goes to conference and this bill
addresses the following component accounting standards.
I commend Chairman Stearns for his hard work on this issue
and for holding this important legislative hearing today.
For reform to be complete, we must address the critical
accounting standards issues. The FASB Act does three main
things. It recognizes FASB's standards as authoritative;
introduces a primary accounting principle to improve
transparency of financial reporting; and requires FASB to
revise accounting standards most abused by Enron and Andersen.
It accomplishes this while maintaining FASB's private
sector status as an independent, something this committee has
always respected.
I support the policies underlined in the FASB Act as
Chairman Stearns' efforts to provide more transparency in
financial reporting.
I thank the witnesses for their testimony today. I want to
give a special, special welcome to the New York connected
members of the panel. Of course, I look forward to the
testimony from all the witnesses, but especially those from New
York.
Thank you very, very much.
Mr. Stearns. I thank my colleague.
Now the distinguished chairman of the Oversight Committee
that did the investigation of Enron, the gentleman from
Pennsylvania, Mr. Greenwood.
Mr. Greenwood. Thank you, Mr. Chairman.
I appreciate the opportunity to sit in as a non-member of
this subcommittee.
By now, we are all familiar with the story that led us
here. On December 2, 2001, Enron Corporation filed for
protection from its creditors under Chapter 11 of the
bankruptcy laws. Two days later, they laid off 4,000 employees.
By mid-December, what had once been the Nation's largest
energy supplier had been reduced to a penny stock and Enron
employees and former employees, who had heavily invested in the
company's stocks through their 401(k) retirement plans, saw
most of their life savings wiped out.
Outside investors, too, suffered heavy losses as nearly $70
billion in assumed equity value simply vanished.
There were many disturbing features to the Enron debacle,
but as I noted at the time, few were as disturbing as what it
might portend for the future if left unaddressed.
For whatever else may be said of the meteoric rise and fall
of Enron, no one can claim that it went unobserved. On the
contrary, few corporations were more admired and few corporate
cultures were more extolled than Enron's.
Yet all the while, Enron's corporate team was busy ginning
up the numbers. As a result, millions of individuals, from the
most sophisticated Wall Street mavens to the most innocent
small town investors, were systematically being deceived.
What we did not know then is the number of other firms that
would so quickly follow in Enron's wake: Tyco International,
Adelphia Communications, Global Crossings, and now ImClone.
Nor was the public sector immune from this new accounting
disease. Amtrak's recent discovery that it had $200 million
more in losses than it had previously thought serves as an
example.
But this morning's news tops them all. WorldCom has
announced that it was guilty of a $3.8 billion accounting
error.
To an increasing number of investors, the who's who of
American corporate executives is beginning to look more and
more like a rogue's gallery. I would hope that this morning's
revelations are enough to convince even those who still cling
to the belief that these failures are merely aberrations, that
they will not be quickly remedied by the self-correcting
mechanisms of the market alone. Not even the street believes
this any more.
As the writers at Fortune magazine wrote in their June 24
cover story, ``Phony earnings, inflated revenues, conflicted
Wall Street analysts, directors asleep at the switch, this
isn't just a few bad apples we are talking about here. Nearly
every known check on corporate behavior, moral regulatory, you
name it, fell by the wayside, replaced by the stupendous greed
that marked the end of the bubble and that has created a crisis
of investor confidence the likes of which has not been seen
since the Great Depression.''
In looking back at the more than 600 audited financial
statements of publicly traded companies that had to be
recalculated downwards in the past 3 years, it is increasingly
clear, that Enron was simply the most egregious example of the
use of ledger domain by corporate management teams in hiding
the truth about a company's actual financial health.
This committee and this Congress are now challenged with
the mission of developing remedies to the accounting and
auditing lapses so that in the future such occurrences are
rare.
At the heart of this matter lies one document, the probity
of which is essential to the credibility of the entire
securities and exchange industry: the annual audited financial
report of a publicly traded company.
The process by which this document is produced is central
to this committee's role in developing new investor safeguards.
That is why I have joined with my colleague, Chairman Stearns,
to introduce legislation that would bring new vitality, a
clearer mission, and greater independence to the Financial
Accounting Standards Board, the body that sets the standards
for auditing.
Our goal is straightforward. To be of genuine value
corporate accounting practices and standards must be
transparent and fully disclosed all the relevant facts needed
by investors to acquire a true understanding of a firm's
economic health.
While I am convinced that this is as much as this committee
can do, given the limits of our jurisdiction, I am also
convinced that this is not all that Congress needs to do.
Bernard Baruch once observed that when the market makes the
front page, sell. I expect there will be a great deal of
selling in the coming days.
The success of market rests fundamentally on the ability of
the buyer to trust the seller. I am hard-pressed to believe
that the true trust relationship of the markets can be restored
without significant congressional action.
The core of that trust relationship is more than an honest
accounting, although that is an essential part. Sound corporate
governance begins with corporate managers, extends to the board
of directors, and finally to the accountants who keep the
company's books.
As Fortune magazine so plainly stated, ``This market is
suffering from a systemic breakdown.''
For that reason, I will shortly be introducing legislation
to establish a market integrity commission, to examine and make
recommendations to Congress and to the business community on
what reform measures are needed to improve the corporate
governance of our Nation's publicly traded companies and to
reestablish investor confidence in our markets.
For while I still hold that most of the reforms of our
capital markets should be undertaken by the private sector, I
also believe that Congress has a responsibility, just as it did
after the market crash in 1929, to insist on the timely
introduction of genuine reforms in corporate governance to
improve the way in which publicly traded companies are
governed, for shareholders and employees, and to strengthen and
safeguard our Nation's economic health.
Thank you, Mr. Chairman.
Mr. Stearns. I thank my colleague.
The gentlelady from California, Ms. Eshoo.
Ms. Eshoo. Good morning, Mr. Chairman and members of the
committee, and welcome to distinguished panel.
Thank you for holding the hearing, Mr. Chairman.
In attempting to prepare for today's hearing, it was
difficult to get our hands on what the language of the bill is
and what exactly is being proposed. As I understand it, the
legislation will give FASB standards a Federal recognition.
Of course, we would like to hear from the distinguished
Chairman of FASB what that means and what kind of prescription
this is for what ails us.
It requires FASB to develop a rule requiring accountants to
apply all FASB standards consistently with the fundamental
principles of transparency and understandability. We are not
doing any of that now? And if we are, then how does this
language apply? How, again, is it going to be a prescription
for what ails us?
It directs FASB to develop rules in areas where current
standards need improvement, specifically off balance sheet
accounting, revenue recognition, and mark-to-market accounting.
I think that FASB needs to weigh in and explain forthwith
how much this is being accomplished today, where this takes us.
Is it strong enough?
My sense is that while the Congress has been, of course, on
the scandals beginning with Enron, that has really rocked our
country, it has shaken the confidence and I think the sense of
decency that the American people believe ultimately prevails.
I think, my sense, as of today, is that we are coming up
short on what we are to do. I want to be sure that what is
being proposed is the right dosage because we can decry what is
going on. An example in terms of energy, the House Energy and
Commerce Committee, to date, has still not weighed in on Enron
and energy suppliers and the abuses that have taken place that
are documented by a Federal agency, the Federal Energy
Regulatory Commission.
So I know the distinguished Chairman and others will weigh
in and that is what I would like to hear.
I would also like to weigh in on an issue that is related.
And I recognize that while Congress has the responsibility to
address these abuses, and I think that we have to come up with
strong prescriptions myself through sensible legislation.
There are some that are using the scandals, starting with
Enron, as a battle cry for what I believe are ill-conceived
proposals like changing the way stock options are valued. The
financial fraud that led to the collapse of Enron, in my view,
had nothing to do with stock options.
By proposing that stock options be counted as an expense
against corporate earnings or expensing them, as the phrase is
used, Congress, I think, is addressing the problem that does
not exist with a solution that does not work.
Financial reports will become less, not more accurate.
There is simply no way to accurately value the potential worth
of employee stock options. And if someone has a way of doing
that, I would like to hear them state it.
Unlike salaries, options are not cash transactions. To
place a value on them, companies would have to make
predictions. Predictions. I think some of these predictions
have gotten us into hot water about the future price of stock,
which employees will stay with the company long enough to
exercise their options, and who would actually choose to do so,
and at what price?
The second negative consequence I think is even worse.
Faced with the exorbitant cost of expensing options, most
companies would simply decide to stop offering them.
I think what is left out of this secondary debate that I am
pointing to, Mr. Chairman, is the following. At the top of
companies and corporations, those at the top will always
somehow do well. I think we would all acknowledge that.
But I have seen over the 10 years--I can't believe that I
have been here for 10 years, but this is my tenth year--I have
seen the rank and file employees win, and win well, under what
I have just described, their stake, their share in their
company and their company's future.
So perhaps this is going to be a part--I am sure it will
be--part of future debates, but I wanted to raise it. I think
it is important. I think we have to separate wheat from chaff.
And I know that our distinguished panel today, I hope and I
trust that they will be forthright with us.
We need solid direction on coming up with solid proposals,
not just political proposals, that the Congress can somehow go
home and say, we had hearings; we brought this up; and now this
is going to be fixed.
I am not an accountant. I guess I am glad that I am not
today, but they must be thought less of than, or running neck
and neck, I think, with politicians. But at any rate, I think
you know my point.
I really would like to know forthwith, without hurting
anyone's feelings, if you think this is actually the strongest
medicine that really needs to apply. We have a huge infection
in our system and it needs to be cured.
Thank you.
Mr. Stearns. I thank the gentlelady.
And now the distinguished chairman of the full committee,
Mr. Tauzin.
Chairman Tauzin. Mr. Chairman, I really appreciate this
hearing and what I hope that we might be able to accomplish as
a result of it and the hearings we have had on the abuses of
both Enron and Arthur Andersen.
The news this morning that another Arthur Andersen client,
WorldCom, has apparently played with the rules and with the
consent of their accountants in the field apparently misstated
current debt by trying to capitalize it over a longer period of
time and in the process overstated income, all to the detriment
of investors, who are entitled to get good information about
companies, like WorldCom and Enron, and others.
And again, we see a common thread here of an accounting
firm, that among the top five accounting firms in America, the
only one that apparently allowed its local auditors the power
to overrule its own quality review boards on the national level
and, therefore, put its own auditors in the field into the kind
of vulnerable situation where a strong and powerful corporate
executive could, in fact, influence their decisions in bending
the rules and reshaping the rules to fit the corporate intent.
If what I read about WorldCom in the Post today is correct,
this fits the pattern, once again. And it calls upon us in our
limited jurisdiction over FASB to do something basic about
changing that pattern.
I appreciate all of you coming today. The last time we had
a session with accounting professors, we learned that the basic
thing wrong with FASB, among all its problems, was that it was
trying to do like the IRS was doing. It was trying to write
intricate rules about what you could not do in accounting.
And so accounting firms, like Arthur Andersen, who allowed
their auditors to be less than fully independent, are
vulnerable to the pressures of a corporate executive who might
want to do something improper, will love to find ways to get
around the FASB rules, to find out how what they did might not
be prohibited by the FASB rule.
We learned from the professors that it would be much wiser
for FASB to be placing strong, clear accounting principles out
there under which accountants must fit what they do in the
field and what they approve in corporate reporting of their
assets and their income and their debts.
I hope that we can agree upon legislation, again within our
limited jurisdiction on FASB, that will force that result, get
FASB to do a better job of making sure that accounting firms
from now on find ways to comply with the rules rather than
constantly be looking for ways to get around a prohibition.
Second, I hope our legislation does something else. I would
appreciate all of you gentlemen commenting on the suggestion
that we give FASB a new authority; that we not only tell them
to change the way they do business, to make sure that this
common thread, if you will, of violations of accounting
principles stops and ends and then investors get better treated
than they have been treated here, but that they also have a
power to do something that I think is critical and I would love
for all of you to comment on it.
We have come to the conclusion that if FASB does not have
the power to do forensic audits. If they cannot from time to
time do what other rulemaking bodies do, and that is go into
the field and actually check to see whether their standards are
being properly applied, to see whether accounting firms are in
fact following the rules rather than trying to get around them;
to see whether or not their standards are up to date or whether
they need to revise them. Because in an information age, there
are changes in the way you look at assets and income and debt.
If they do not have the power to go in and check the
performance of their standards in the field from time to time,
they will always be behind the eight ball, always be late
updating their rules, always be too slow, always be in a
position where some smart accountant and some bright executive
are ahead of them doing something they should not be doing.
And that, I think, is one of the critical reforms I think
we need to make again within the limited jurisdiction we have
on this issue. I think it flows from all of what we have
learned in the Enron hearings up until this date.
So I know I have very limited time, but I would love if any
of you would--are we in question and answer period yet?
We are not.
Mr. Stearns. Just in opening statements.
Chairman Tauzin. I would love if any of you, during the
question and answer period, would focus some attention on that
central question. Should we give FASB that authority? Without
that authority, can FASB do its job?
Let me make one final point because the paper talks about
this in a political sense as well. Anyone who believes in the
capital markets, as we do, anyone who supports the notion of
capitalism and free markets and the business economy of this
country, which has been a leader in the world, anyone who
supports the principles under which free enterprise operates
ought to be more offended by corporate misbehavior than by
anyone who does not.
And those of us who do are incredibly offended when we see
corporations run by people who put avarice ahead of the good of
the investors in the corporation. And all of us are offended
when accounting firms operate in a fashion that they allow
independence to go out the window and they permit the kind of
simple and fundamental violations of the rules, as we have seen
in the paper today, where you would capitalize current charges
just to inflate income and hide debt and, therefore, hurt
investors of your company and hurt your company in the long
run.
All of us are offended by that. And anybody who think that
those of us who support capitalism and support the free markets
in this country are less offended by it than anybody else is
wrong. In fact, perhaps more so.
It is like a member of your own family doing something
wrong instead of the neighbor. You get a little more upset
about it. And so I hope we disabuse that notion in this
country. I think our hearings on Enron, our hearings on Arthur
Andersen, and I hope the work we do in reforming FASB make that
case over and over again. The Democrats and Republicans are
equally offended by what we have seen, and it has got to come
to an end for the good of the markets and for the good of
investor confidence again, in this economy if we are going to
get it rolling again as we hope to get it rolling.
Thank you, Mr. Chairman.
[The prepared statement of Hon. W.J. ``Billy'' Tauzin
follows:]
Prepared Statement of Hon. W.J. ``Billy'' Tauzin, Chairman, Committee
on Commerce
One year ago, ``transparent reporting and ``auditor independence
were not household phrases. Today they are. The Enron implosion ushered
in a process in which many Americans who previously paid little
attention to the intricacies of accounting became more concerned and
more attentive to important, if nuanced, accounting issues. Let me be
clear--the behavior of Enron and Andersen was truly atrocious. Yet the
sunlight that has been shed on the deficiencies in our market system,
much of it by this Committee, will ultimately work to improve that
system. As investors digested the news about corporate managers helping
themselves to shareholder assets while the shareholder's watchdogs
looked the other way and Wall Street analysts continued to hype tanking
stocks, they began to demand strong oversight of the standards for
recording and reporting public companies' financial information.
This Committee held a series of hearings exposing the abuses at
Enron and Andersen and exploring deficiencies in current accounting
practices. In fact, some of the same witnesses we heard from early in
the process are here again today. I thank them for returning. I also
thank the rest of our panel for taking the time to provide guidance on
our accounting standards legislation. Chairman Stearns and Chairman
Greenwood have worked tirelessly to get to the root of the problems and
develop a viable solution and I thank them too, for all of their
important efforts.
Our somewhat limited jurisdiction made meaningful reform of
accounting standards in this committee alone difficult. We worked hard
to fulfill our oversight obligations and help protect the investing
public from the deficiencies in transparency and comprehensibility of
financial information.
That said, the Committee Print of the Financial Accounting
Standards Board Act makes important improvements to financial
reporting. The bill introduces the benefits of a principles-based
accounting system into our rule-based system by requiring FASB check
the accounting standards against the principles of transparency and
comprehensibility. It also requires FASB to draft a primary standard
that must be used to ensure the application of accounting rules
complies with those same principles of transparency and
comprehensibility. Any deviation in the application of a rule from the
principles articulated in the bill must be explained and justified. The
bill also requires FASB to finish work on accounting projects that have
been ongoing for too long. Those projects include work on revenue
recognition, which I understand has been under some consideration by
FASB for 26 years, and off-balance sheet accounting that has been open
for more then ten years. The legislation also calls upon FASB to
complete it work on its fair value project.
Off ``balance sheet accounting was subject to great abuse by Enron
and all members are united in the view that it is imperative to reform
these rules.
The Committee has an obligation to exercise, not only its oversight
jurisdiction, but also its legislative jurisdiction in the area of
accounting standards. The legislation we consider today will lead to
improvements in the transparency of financial information. Once again,
I thank the witnesses for their testimony and assistance and look
forward to hearing what each has to say.
Mr. Stearns. I thank the chairman.
The distinguished ranking member of the full committee, Mr.
Dingell.
Mr. Dingell. Mr. Chairman, I thank you for recognizing me.
I commend you for holding this hearing on legislation to
improve the accounting standards setting process. You, our
Chairman, Mr. Tauzin, Ranking Member Towns, and I all support
the work of the Financial Accounting Standards Board, FASB. And
we care deeply about its independence, which we think is
necessary for a strong, truthful, respected and trustworthy
accounting industry.
I, therefore, strongly support the goals of this committee
print and the bipartisan efforts to strengthen FASB.
The jurisdictional constraints that the House rules impose
on this committee--and we have jurisdiction over the FASB
standard setting process, but no jurisdiction over the central
role of the Securities and Exchange Commission in development
of standards and its oversight of FASB--severely complicate the
efforts of this committee to address the crucial implementation
issues, such as those identified in Professor Dharan's
excellent testimony.
I look forward to the testimony of all the witnesses this
morning. And I want you to know that I will try to work with
them and you, Mr. Chairman, and others on this committee to
perfect and strengthen this bill so it does what has to be
done.
I and others have often said that Enron was not unique,
that there were other ticking time bombs out there. Subsequent
events have born that regrettable warning out. In the latest
blow to our economy and investor confidence in the stock
market, we were met this morning with news in the paper that
says WorldCom's audit committee has uncovered what could be the
largest accounting fraud in history, the discovery that $3.8
billion in expenses was improperly booked as capital
expenditures.
I would note that appears to be either an act of severe
criminality or an event which, very frankly, could not have
been committed by a beginning student of accounting.
I would note this committee should immediately commence a
full investigation, and I pledge my help in that work.
Chairman Levitt of the SEC warned loud and long about
corrupt financial management and their complicit auditors. His
campaign against earnings management, or falsifying revenue to
boost stock prices, was documented by Fortune magazine in such
articles as ``Presto Chango, Sales are Huge,'' and ``Lies,
Damned Lies and Earnings Management,'' or perhaps it might have
been just ``Lies, Damned Lies and Accounting.''
In any event, very few people wanted to hear what he had to
say because they were too busy making too much money on the
resultant run-up in stock prices. Regrettably, that party is
over and we all have a hangover. And we must all do our part to
clean up this sorry mess.
In April, the House passed a bill which could best be
denominated as halfhearted or perhaps half-witted reform. As
Business Week warned in a June 3 editorial, ``Halfhearted
reform is bad for the public, bad for the economy, and even bad
for the accounting industry, which needs to establish its
credibility.'' That is why it is so important for the Congress
to now take up and pass the Sarbanes bill at the earliest
opportunity.
FASB is not responsible for the wave of accounting
scandals. These companies and their auditors violated existing
accounting and auditing standards. Crooks are going to be with
us always. We must nonetheless look to see what we can do to
enhance and strengthen FASB and to improve the standard-setting
process. I stand ready to assist in that process.
I would just note one thing else. I have warned industry
time after time that this country has a most unique and
wonderful asset in our financial markets: they are trusted by
the American people.
I warned the financial industry of something else.
Everybody thought that this system ran on money. It does not.
It runs on public confidence. As long as the public has
confidence, there will be much money made by all.
I would just read one last point that shows that everybody
has a stake in this matter, and that is on page 1 of the
Washington Post. I would urge the reading of this article,
``Corporate Scandals Taking Toll On the Markets.'' They are
skimming a bunch of innocent people in the marketplace, people
who trusted corporate managers, accountants, the Federal
agencies to regulate, the Congress to pass good laws and see
that they are properly enforced. All of the above have failed
in a most noteworthy fashion. And until we can straighten out
this sorry mess and get people to have confidence, we should
not look to much confidence in the market, nor should we look
to the fact that good times are going to be here again in the
financial services industry.
I thank you, Mr. Chairman.
[The prepared statement of Hon. John D. Dingell follows:]
Prepared Statement of Hon. John D. Dingell, a Representative in
Congress from the State of Michican
Mr. Chairman, I commend you for holding this important hearing on
legislation to improve the accounting standards-setting process. You,
Chairman Tauzin, Ranking Member Towns, and I all support the work of
the Financial Accounting Standards Board (FASB) and care about its
independence. I therefore strongly support the goals of this committee
print and bipartisan efforts to strengthen FASB.
The jurisdictional constraints that the House Rules impose on this
Committee--we have jurisdiction over FASB's standard setting process
but no jurisdiction over the central role of the Securities and
Exchange Commission in the development of standards and its oversight
of FASB--severely complicate our efforts to address critical
implementation issues such as those identified in Professor Dharan's
testimony. I look forward to the testimony of all of the witnesses this
morning, and I will continue to work to perfect and strengthen this
bill.
I and others have often said that Enron was not unique, that there
were other ticking time bombs out there. Subsequent events have borne
that warning out. In the latest blow to our economy and to investor
confidence in the stock market, we were met this morning with news that
WorldCom Inc.'s audit committee has uncovered what could be one of the
largest accounting frauds in history, with the discovery of $3.8
billion in expenses improperly booked as capital expenditures. This
Committee should immediately commence a full investigation, and I
pledge my help in that work.
SEC Chairman Arthur Levitt warned loud and long about corrupt
corporate financial management and their complicit auditors. His
campaign against earnings management or falsifying revenue to boost
stock prices was documented by Fortune magazine in such articles as
``Presto Chango! Sales are Huge!'' and ``Lies, Damned Lies, and
Earnings Management.'' Perhaps it should have been entitled ``Lies,
Damned Lies, and Accounting.''
Very few people, however, wanted to hear what he had to say because
they were too busy making too much money on the resultant runup in
stock prices. That party is over and we all have a hangover. We must do
our part to clean up this sorry mess. In April, the House passed
halfhearted, some say half-witted, reform. As Business Week warned in a
June 3 editorial: ``Halfhearted reform is bad for the public, bad for
the economy, and even bad for the accounting industry, which needs to
reestablish its credibility.'' That is why it is so important for
Congress to take up and pass the Sarbanes bill at the earliest
opportunity.
FASB is not responsible for the wave of accounting scandals. These
companies and their auditors violated existing accounting and auditing
standards. Crooks will always be with us. We must nonetheless look to
what we can do to enhance and strengthen FASB and improve its standard-
setting process. I stand ready to assist in that task.
I have warned time after time that the market is not driven by
money, but rather by public confidence. I would note an article on the
front page of the Washington Post today entitled, ``Corporate Scandals
Taking Toll On Markets'' that details how corrupt accounting has turned
profits by skimming off innocent people in our financial markets and
that, in turn, has begun to weigh heavily on the stock market, the
dollar, and the U.S. economy. The United States has a unique financial
system that is trusted by the American people. If Americans lose faith
in the system, we should not look for good times in the future.
Mr. Stearns. I thank the ranking member.
The gentlemen from New Hampshire, Mr. Bass.
Mr. Bass. Thank you, Mr. Chairman.
I appreciate you holding this important hearing on
accounting standards and featuring the Financial Accounting
Standards Board.
A very tiny percentage of the total accounting community
has potentially committed serious crimes and they ought to pay
for those crimes. They ought to go to jail, if that is what is
determined by the judicial system.
I agree with much of the discussion or statements that have
been made by the ranking member of the committee, as well as
the chairman, about the system needing reform. Perhaps the
reform measures that we have undertaken have not done
everything that needs to be done, but I am concerned about the
criticism of, ``halfhearted reform'' versus over-reform or
overregulation which could have not only unintended
consequences, but also create significant costs to the business
community that 99.9999 percent of the business community that
is trying to operate aboveboard.
I would also observe that the rest of the financial
services community has an affirmative responsibility to be more
attentive and more inquisitive about the accounting practices
of the corporations that they choose to become associated with
in the form of investments.
So FASB needs to remain independent, but there is an
affirmative responsibility that FASB respond to the crises that
we are facing every day now from certain major corporations.
But we, as Members of Congress, have to be careful not to
create monsters that are worse than the ones that we are facing
today.
And I yield back.
Mr. Stearns. Thank you, gentlemen.
The gentlelady from Colorado, Ms. DeGette.
Ms. DeGette. Thank you, Mr. Chairman.
When I was in college, I took accounting, and I remember at
that time accounting was perceived as just a cut and dried,
almost a trade type of class. In fact, they had debates within
my liberal arts institution whether they should even teach
accounting because it was just a matter of keeping the books.
And what we have learned in the many years since I
graduated from college is that there are a few people within
the corporate community in this country, who have elevated
accounting to a spectacular new art form and, in fact, have
used the FASB standards and generally accepted accounting
principles in a way that masks the true financial condition of
companies and serves not only to mislead investors, but to
undermine the markets, which Mr. Dingell spoke so eloquently
about.
The question this committee has to address is what can we
do; what kind of order can we put to this, so that these new
artists, who have become so skilled in manipulating accounting
standards can be stopped and that we can have true transparency
in corporate financial statements.
This committee has done a commendable job following the
collapse of Enron in holding hearings to decide what will work
and what will not work. Of course, with this announcement about
WorldCom overstating its earnings by $3.8 billion, the sense
this committee should have of urgency is even greater.
Having said that, I think it is important that Congress not
rush to make dramatic changes without deliberative and careful
analysis. The reason is simply acting will not solve the
problem.
And as I look at the bill that we are considering today,
the Financial Accounting Standards Board Act, I fear that it
will at best essentially reform current practices, but at worst
it could inhibit the standard-setting obligations of FASB.
The bill purports to increase the effectiveness of FASB by
giving accounting standards Federal recognition. But the SEC
currently has statutory authority to recognize accounting
standards and, in fact, has recognized the standards set by
FASB as being authoritative.
Furthermore the SEC requires companies to use GAAP in
developing their financial statements. And so that is, in
essence, Federal recognition of FASB standards.
On the other side, this bill could potentially harm FASB
because if it were passed into law, then FASB would be required
to report on the use of standards by the business community.
And as we saw in Mr. Jenkins' preview of his testimony,
this requirement could be costly to FASB and drain away
precious resources that would be more appropriately used on
other things.
The requirement that FASB promulgate a primary standard
could have the same financial and resource depleting effects.
FASB would be forced to use precious resources to develop a
very vague standard based on a set of principles that companies
could wiggle their way out of with ease.
So rather than passing a bill that simply restates the
status quo and then having us all very smugly go back and say,
``We fixed the problem,'' I think we should look long and hard
at H.R. 3970, the Truth and Accountability in Accounting Act
that was introduced in March by Mr. Dingell and several other
members of the committee, including myself.
The bill does not directly affect FASB, but there is one
provision relating to FASB that requires the SEC to report
annually on FASB's progress in resolving these unfinished
issues.
Instead what this bill does is increase corporate
accountability by requiring the CEO and CFO of every company to
attest to the fair representation of their financial
statements. Enron's Board of Directors and senior officers
claimed they did not know what was in the financial statements.
They were just off the truck, I guess, from the farm and they
did not know what was going on.
This provision in H.R. 3970 would ensure that senior
executives knew, and more importantly, were accountable for
what they were reporting to the SEC or the public, or they
would face criminal penalties.
H.R. 3970 also establishes a new independent board to
develop auditing standards for the accounting profession. Every
accounting firm would be required to register with the board in
order to audit corporate financial statements. This, along with
other provisions of the bill, would make it much more difficult
for accounting firms to shirk their duties.
There are many other fine provisions of the legislation,
which is why I think we should bring folks in to talk about
that bill, auditor independence, adequate resources, dues, and
on and on.
So, therefore, Mr. Chairman, I would respectfully submit
that we would accomplish more or at least as much if we had
hearings on H.R. 3970 and tried to make progress in improving
transparency, investor confidence and corporate governance.
And I yield back the balance of my time.
[The prepared statement of Hon. Diana DeGette follows:]
Prepared Statement of Hon. Diana DeGette, a Representative in Congress
from the State of Colorado
Thank you, Mr. Chairman. Following the collapse of Enron, this
subcommittee and the Subcommittee on Oversight and Investigations
examined how it was that Enron duped the market and so severely over-
stated its earnings. We found a combination of problems.
Enron took advantage of certain unresolved accounting issues to
purposely omit information from its financial statements. Additionally,
Enron violated certain existing generally accepted accounting
principles. And, apparently, Enron wasn't alone. Last night, WorldCom
announced that it had overstated its earnings by $3.8 billion.
Thankfully, Mr. Chairman, this committee realized that something must
be done, and took prompt action by holding a series of very important
and productive hearings. And I thank you for scheduling this hearing to
continue the very important work of this committee in developing ways
to increase investor confidence, transparency on financial statements,
and corporate governance.
In order to correct what went wrong with Enron, I believe it is
important that Congress not rush to make dramatic changes without
deliberative and careful analysis. However, we also must act. We cannot
simply turn our heads from the problem, or even worse, pass bills that
would not provide solutions.
I believe the ``Financial Accounting Standards Board Act'' would,
at best, essentially reaffirm current practice and at worst, inhibit
the standard-setting obligations of the Financial Accounting Standards
Board (FASB). The bill purports to increase the effectiveness of FASB
by giving accounting standards federal recognition. Yet, the SEC
currently has statutory authority to recognize accounting standards,
and has recognized the standards set by FASB as being authoritative.
Furthermore, the SEC requires companies to use GAAP--generally accepted
accounting principles--in developing their financial statements. This
is essentially federal recognition of FASB standards.
I fear that this bill could potentially harm FASB. If the bill were
passed into law, FASB would be required to report on the use of its
standards by the business community. As Mr. Jenkins will testify, this
requirement would be costly to FASB and could drain away precious
resources that would be more appropriately used on other things.
The requirement that FASB promulgate a ``primary standard'' could
have the same financial and resource-depleting effects. FASB would be
forced to use precious resources to develop a very vague standard based
on a set of principles that companies could wiggle their way out of
following.
Rather than considering a bill that would simply re-state the
status quo, I believe this subcommittee should be considering H.R.
3970, the ``Truth and Accountability in Accounting Act'' that was
introduced in March by the ranking member of the full committee, Mr.
Dingell, and several other members of the committee, including myself.
This bill would not directly affect FASB. In fact, the only provision
relating to FASB is one that requires the SEC to report annually on
FASB's progress in resolving unfinished issues.
Instead, H.R. 3970 would increase corporate accountability by
requiring the CEO and CFO of every company to attest to the fair
representation of their financial statements. Enron's board of
directors and senior officers claimed they did not know what was in
their financial statements. This provision would ensure that senior
executives know and be accountable for what they are reporting to the
SEC and the public, or they will face criminal penalties.
H.R. 3970 would also establish a new independent board to develop
auditing standards for the accounting profession. Every accounting firm
would be required to register with the board in order to audit
corporate financial statements. This, along with other provisions in
the bill, would make it much more difficult for accounting firms to
shirk their duties.
Additionally, H.R. 3970 would ensure that the independent board has
adequate resources by requiring each accounting firm to pay annual
dues. One of the problems that the witnesses here today will point out
in the FASB Act is the lack of a truly independent funding system for
FASB. H.R. 3970 would not require the independent board to seek its own
funding; it would require each accounting firm to pay fees to help fund
its operations.
Finally, the bill would mandate auditor independence through an
approval mechanism by the board. In our Enron investigations, we saw
that auditors became too cozy with big corporations to effectively
fulfill their obligations to the investor. By prohibiting certain
consulting services and requiring auditor rotation, H.R. 3970 would
make accounting firms more accountable to the public.
Therefore, Mr. Chairman, I respectfully submit that this
subcommittee would accomplish more if it were to hold hearings on H.R.
3970 and make progress in improving transparency, investor confidence,
and corporate governance.
Mr. Stearns. The gentleman from Massachusetts, Mr. Markey.
Mr. Markey. Thank you, Mr. Chairman.
Let me begin by expressing my sincere appreciation to FASB
Chairman Ed Jenkins, who will soon be stepping down. Chairman
Jenkins, I have had the please of meeting with you on numerous
occasions over the last several years, and I have always been
impressed by your commitment to the public interest, to high
standards of fairness and accuracy in accounting, and above
all, to your commitment to maintaining the independence and
impartiality of FASB, often in the face of intense lobbying by
corporate America or by the Congress, for you to allow opaque
and confusing accounting principles.
You have been at the helm of the FASB during a difficult
period, and we thank you for your service to the institution.
The crisis we are in today is less a reflection of FASB
standard setting and more a reflection of the accounting
profession's systems dramatic efforts to evade the principles
upon which FASB is based.
And make no mistake, we are in a crisis, a crisis of
corporate irresponsibility; a crisis of investor confidence.
This crisis threatens the very foundations of our financial
markets, the markets that serve as the engine of our national
economy and which provide the productive capital needed to
finance new products, develop new technologies, create new
jobs, and drive future economic growth.
Each day, the papers bring us new revelations of ``cooked
books,'' imperious and unaccountable corporate chieftains who
have looted their companies and mislead their investors with
fraudulent, misleading, or inflated financial statements. From
Enron to Global Crossings to WorldCom, we are learning more and
more about the financial house of cards that certain companies
erected during the stock market bubble.
Now that this bubble has burst, investors are questioning
whether they can trust the financial statements and disclosures
they are receiving.
This loss of investor confidence is broad and deep. And it
is directly contributing to the broad collapse in stock prices
that we have seen over the last several months, a collapse that
has wiped out all the gains made since the markets tumbled in
the aftermath of September 11.
The accounting profession has played a central role in this
crisis. And the profession bears much of the blame for the
sorry state we now find ourselves in.
Years ago, the big accounting firms decided that they
wanted to trade in their green eye-shades for the lucrative
profits available to the consulting business. They decided that
they wanted to simultaneously serve as referees and players in
the game of business and finance.
In doing so, the big accounting firms abandoned their
public responsibility to investors for private gains.
CPA used to stand for Certified Public Accountant. Now CPA
stands for Corporate Piracy Accomplices.
Arthur Andersen appears to have been an active and witting
accomplice to Enron's fraud, and it and the other major firms
appear to have aided and abetted many of the other frauds that
we have learned about in recent months.
It has done so by gaming the accounting standards
established by the FASB, to justify virtually every shady deal
or unscrupulous scheme proposed by greedy and corrupt corporate
managements.
How else can we understand Andersen allowing Enron's
special purpose entities to keep off the company's balance
sheets.
Today we consider legislation to reform FASB. I look
forward to hearing the testimony on how this can be best
accomplished. But as we consider reforms in the accounting
area, I also think we need to look beyond FASB.
We need to establish a strong accounting oversight and
regulatory body with real investigative and enforcement powers
to root out wrongdoing. The toothless legislation passed by the
House a few months ago fails to create the kind of body we need
to police the profession.
In addition, we need to revisit the ill-conceived
security's litigation reform legislation adopted by the
majority on this committee as part of Newt Gingrich's Contract
with America.
That legislation's Catch-22 discovery stay, its heightened
pleading standards, its eliminating of joint and several
liability has seriously impaired the rights of defrauded
investors. We need to restore the right of investors to sue
aiders and abettors of securities frauds, a right which the
Supreme Court wrongly denied investors in the Central Bank of
Denver decision.
Today the SEC can sue aiders and abettors, but defrauded
investors cannot. The Andersen and many other of the Enron
defendants are trying to hide behind this loophole to escape
full liability for their misdeeds. We should not let that
happen to defrauded investors.
Today's hearing will help us to connect the dots so that we
can place the responsibility where it belongs. And then, we
must take the corrective action that protects tens of millions
of families who have lost money because they do not have right
now the protections in place to ensure that their families are
protected.
Thank you, Mr. Chairman.
[The prepared statement of Hon. Edward J. Markey follows:]
Prepared Statement of Hon. Edward J. Markey, a Representative in
Congress from the State of Massachusetts
Thank you, Mr. Chairman, for calling today's hearing.
We are in a crisis. A crisis of corporate irresponsibility. A
crisis of investor confidence. This crisis threatens the very
foundations of our financial markets--the markets that serve as the
engine of our national economy and which provide the productive capital
needed to finance new products, develop new technologies, create new
jobs, and drive future economic growth.
Each day, the papers bring us new revelations of cooked books,
imperious and unaccountable corporate chieftains who have looted their
companies and mislead their investors with fraudulent, misleading, or
inflated financial statements. From Enron to Global Crossing, to
Worldcom, we are learning more and more about the financial house of
cards that certain companies erected during the stock market bubble.
Now that this bubble has burst, investors are questioning whether they
can trust the financial statements and disclosures they are receiving.
This loss of investor confidence is broad and deep, and it is directly
contributing to the broad collapse in stock prices that we have seen
over the last few months--a collapse that has wiped out all of the
gains made since the markets tumbled in the aftermath of September
11th.
The accounting profession has played a central role in this crisis,
and the profession bears much of the blame for the sorry state we now
find ourselves in. Years ago, the big accounting firms decided that
they wanted to trade in their green eyeshades for the lucrative profits
available in the consulting business. They decided that they wanted to
simultaneously serve as referees and players in the game of business
and finance. In so doing, the big accounting firms abandoned their
public responsibility to investors for private gains. CPA used to stand
for ``Certified Public Accountant.'' Now CPA stands for ``Corporate
Piracy Accomplices.''
Arthur Anderson appears to have been an active and witting
accomplice to Enron's fraud, and it and the other major firms appear to
have aided and abetted many of the other frauds that we have learned of
in recent months. They have done so by gaming the accounting standards
established by the Financial Accounting Standards Board to justify
virtually every shady deal or unscrupulous scheme proposed by greedy
and corrupt corporate managements. How else can we understand
Anderson's allowing Enron's ``special purpose entities'' to be kept off
the companies balance sheets?
Today, we consider legislation to reform FASB. I look forward to
hearing the testimony on how this can be best accomplished. But as we
consider reforms in the accounting area, I also think we need to look
beyond FASB. We need to establish a strong accounting oversight and
regulatory body with real investigative and enforcement powers to root
out wrongdoing. The toothless legislation passed by the House a few
months ago fails to create the kind of body we need to police the
profession. In addition, we need to revisit the ill-conceived
securities litigation ``reform'' legislation adopted by the Majority on
this Committee as part of Newt Gingrich's ``Contract with America.''
That legislation's ``Catch 22'' discovery stay, it's heightened
pleading standards, and its elimination of joint and several liability
has seriously impaired the rights of defrauded investors. We also need
to restore the right of investors to sue ``aiders and abettors'' of
securities frauds, a right which the Supreme Court wrongly denied
investors in the Central Bank of Denver decision. Today, the SEC can
sue aiders and abettors, but defrauded investors cannot. Anderson and
many of the other Enron defendants are trying to hide behind this
loophole to escape full liability for their misdeeds. We should not
allow that to happen.
Today's hearing will help us connect the dots to place the
responsibility where it belongs. Hopefully, we will soon be able to
come up with some solutions that will help restore the investor
confidence that is so necessary to the functioning of our nation's
markets.
Thank you.
Mr. Stearns. I thank the gentleman.
Now let's go to our first and only panel.
We have Mr. Edmund Jenkins, who is Chairman of the
Financial Accounting Standards Board.
We have Dr. Bala Dharan, J. Howard Creekmore Professor of
Management, the Jesse H. Jones Graduate School of Management at
Rice University.
John C. Coffee, Jr., Adolf A. Berle Professor of Law,
Columbia University Law School.
Baruch Lev, Philips Bardes Professor of Accounting and
Finance, Department of Accounting Taxation and Business Law and
Department of Finance, the Director of the Vincent C. Ross
Institute of Accounting Research, Stern School of Business, at
NYU.
And Honorable Ned Regan, President of Baruch College in New
York.
Thank you very much for your patience. We would like to
have your opening statements.
Mr. Jenkins, I will go from my left to my right.
STATEMENTS OF EDMUND L. JENKINS, CHAIRMAN, FINANCIAL ACCOUNTING
STANDARDS BOARD; BALA G. DHARAN, J. HOWARD CREEKMORE PROFESSOR
OF MANAGEMENT, JESSE H. JONES GRADUATE SCHOOL OF MANAGEMENT,
RICE UNIVERSITY; JOHN C. COFFEE, JR., ADOLF A. BERLE PROFESSOR
OF LAW, COLUMBIA UNIVERSITY LAW SCHOOL; BARUCH LEV, PHILIPS
BARDES PROFESSOR OF ACCOUNTING AND FINANCE, DEPARTMENT OF
ACCOUNTING TAXATION AND BUSINESS LAW & DEPARTMENT OF FINANCE,
DIRECTOR, VINCENT C. ROSS INSTITUTE OF ACCOUNTING RESEARCH,
STERN SCHOOL OF BUSINESS; AND NED REGAN, PRESIDENT, BARUCH
COLLEGE
Mr. Jenkins. Thank you, Chairman Stearns, Ranking Member
Towns, and members of the subcommittee.
I appreciate the invitation to share my thoughts on the
discussion draft of the Financial Accounting Standards Board
Act. I am going to refer to it in my remarks as the discussion
draft, if I may.
I have brief prepared marks, and I would respectfully
request that the full text of my testimony and all supporting
materials be entered into----
Mr. Stearns. By unanimous consent, so ordered.
Mr. Jenkins. Thank you.
The Financial Accounting Standards Board as you have
acknowledged is an independent private sector organization. We
are not part of the Federal Government. Our independence from
the Federal Government reporting enterprises, and auditors is
fundamental to achieving our mission. That mission is to set
accounting and reporting standards to protect consumers of
financial information, most notably, investors and creditors.
Those consumers rely heavily on credible, transparent, and
comparable financial reports for effective participation in the
capital markets.
The FASB has no power to enforce its standards.
Responsibility for ensuring that financial reports comply with
accounting standards rests with officers and directors of the
reporting enterprise, with the auditors of the financial
statements of those enterprises, and for public companies,
ultimately with the SEC.
The FASB also has no authority with respect to auditing,
including auditor independence. Chairman Greenwood commented on
that. Nor do we have any responsibility with respect to scope
of services.
Rather, our responsibility relates solely to establishing
accounting and reporting standards.
I understand and appreciate the important role that this
subcommittee has with respect to the FASB. I believe it is
entirely appropriate and beneficial to the FASB, consumers, and
to the capital markets for this subcommittee to exercise its
oversight authority to ensure that we are fulfilling our
mission and responsibilities in the public interests.
I, therefore, do not oppose, as I explain in the full text
of my testimony, certain of the provisions of the discussion
draft that address the FASB's process.
I, however, also strongly believe, as I believe do most of
our constituents, including most consumers and most Members of
Congress, and it has been mentioned here this morning already,
several times that it is inappropriate and potentially harmful
to consumers in the capital markets for Congress to mandate the
subject matter, the content, the technical aspects or the
timing of our technical decisions on standards. I, therefore,
cannot support, again, as explained in the full text of my
testimony, certain other provisions of the discussion draft
that address the FASB's technical activities.
Just during my 5 years as Chairman of the FASB, on two
different occasions in which the FASB was proposing major
improvements to the transparency of financial reports, several
Members of Congress either introduced, or threatened to
introduce, legislation, legislation that if enacted would have,
at a minimum, significantly delayed the needed improvements the
FASB was proposing.
In other cases, the legislation, if enacted, would have
essentially eviscerated the FASB.
On both occasions the FASB, with the support of many
constituents, including consumers, and members of this
subcommittee, successfully responded to those challenges, and
final standards were issued that dramatically improved the
transparency of financial reports. Responding to those
challenges, however, diverted some of the limited resources of
the FASB, resources that otherwise would have been devoted to
the FASB's primary mission of improving accounting standards to
protect consumers.
Thus, my experience as Chairman of the FASB, has led me to
conclude that this subcommittee's oversight and input can be
quite valuable to the Board. Members of Congress, however, must
avoid the urge to legislate technical accounting standards and
must reject the facile arguments and emotional appeals
sometimes made by constituents claiming that FASB proposals
will destroy Western civilization as we know it.
Over 60 years of history conclusively demonstrate that
accounting standards that result in more transparent financial
reporting enhance, rather than hinder, the US economy.
I am very confident that my successor as Chairman of the
FASB, Bob Herz, will demonstrate to this subcommittee and all
who participate in the capital markets that he has the
leadership and technical skills necessary to ensure that the
FASB continues to provide the markets with high quality
accounting standards, standards that will result in more
transparent and credible financial reports in the months and
years ahead.
Before I conclude, let me comment briefly on WorldCom. From
what I read in the papers today, WorldCom seems to be another
example, like Enron, where there was a failure on the part of
company's management, perhaps its auditors, to follow existing
generally accepted standards.
These issues seem to me, with all due respect, to be issues
related to corporate governance, the tone at the top, rather
than primarily issues related to accounting standards as they
exist today.
That does not mean that we do not need to improve existing
accounting standards. We do. We are. And we have other things
in process that will continue that process.
Thank you again, Mr. Chairman. I very much appreciate your
interest in, and support of, the independence of the FASB.
I also want to thank you, Mr. Chairman, Ranking Member
Towns, and all of the members of the subcommittee for the
personal support you have graciously provided to me over the
past 5 years, and for the comments you made this morning.
Thank you.
[The prepared statement of Edmund L. Jenkins follows:]
Prepared Statement of Edmund L. Jenkins, Chairman, Financial Accounting
Standards Board
Chairman Stearns, Ranking Member Towns, and Members of the
Subcommittee: I am pleased to appear before you today on behalf of the
Financial Accounting Standards Board (``FASB'' or ``Board''). My
testimony includes a brief overview of the FASB and our structure and
process, a summary of the Board's significant technical activities
since I last testified before this Subcommittee on February 14, 2002,
and a summary of some of the Board's other current projects. My
testimony includes a brief summary of the FASB's views on the June 18,
2002, Discussion Draft of the Financial Accounting Standards Board Act
(``Discussion Draft''). My testimony also includes a brief discussion
of Enron Corp.'s (``Enron'') failure to comply with existing accounting
requirements. Finally, my testimony concludes with some brief summary
remarks.
what is the fasb, what does it do, and what has it done lately?
The FASB is an independent private-sector organization. We are not
part of the federal government. Our independence from enterprises,
auditors, and the federal government is fundamental to achieving our
mission--to establish and improve standards of financial accounting and
reporting for both public and private enterprises. Those standards are
essential to the efficient functioning of the markets because
investors, creditors, and other consumers of financial reports rely
heavily on credible, transparent, and comparable financial information.
The FASB's authority with respect to public enterprises comes from
the US Securities and Exchange Commission (``SEC''). The SEC has the
statutory authority to establish financial accounting and reporting
standards for publicly held enterprises. For more than 60 years, the
SEC has looked to the private sector for leadership in establishing and
improving those standards. The SEC maintains active oversight of
private sector accounting standard setting, including oversight of the
FASB. The SEC issues an annual report to Congress describing those
oversight activities.
The FASB's standards govern only the information contained in
enterprises' financial reports--financial statements and accompanying
notes. Those reports are only one element of the broader universe of
information provided by enterprises to the public. Other important
information for consumers includes management's discussion and
analysis, information (in addition to the financial statements and
accompanying notes) provided in an enterprise's annual report,
presentations to analysts, fact books, and information provided on an
enterprise's website.
The FASB has no power to enforce its standards. Responsibility for
ensuring that financial reports comply with the FASB's standards rests
with the officers and directors of an enterprise, the auditors of the
financial statements, and for public enterprises, ultimately with the
SEC. Generally, when an enterprise restates its financial reports, it
publicly acknowledges that it has failed to comply with existing
accounting standards.
The FASB also has no authority or responsibility with respect to
auditing standards and issues, including the independence of auditors
and the scope of services of auditors. Moreover, we have no authority
or responsibility with respect to the ethical code or requirements of
the accounting profession. Rather, our responsibility relates solely to
establishing financial accounting and reporting standards.
The focus of the FASB is on consumers--users of financial reports,
such as investors, creditors, and others. We attempt to ensure that
financial reports give consumers an informative picture of an
enterprise's financial condition and activities and do not color the
image to influence behavior in any particular direction.
The US capital markets continue to be the deepest, most liquid, and
most efficient markets in the world. The unparalleled success and
competitive advantage of the US capital markets are due, in no small
part, to the high-quality and continually improving US financial
accounting and reporting standards. As Federal Reserve System Chairman
Alan Greenspan stated:
Transparent accounting plays an important role in maintaining
the vibrancy of our financial markets . . . An integral part of
this process involves the Financial Accounting Standards Board
(FASB) working directly with its constituents to develop
appropriate accounting standards that reflect the needs of the
marketplace.1
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\1\ Letter from Federal Reserve System Chairman Alan Greenspan to
SEC Chairman Arthur Levitt (June 4, 1998).
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As an update since I last testified before the Subcommittee on
February 14, 2002, some of the FASB's more significant technical
activities have included the following:
Issuance of a standard that updates, clarifies, and simplifies
several existing accounting requirements, including
requirements relating to the accounting for leases.2
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\2\ See FASB Statement No. 145, Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections (April 2002). See Attachment 1 for News Release, FASB
Issues Financial Accounting Statement No. 145 (April 30, 2002).
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Issuance of a proposal that would increase the consistency of
the reporting for derivatives.3
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\3\ See Exposure Draft, Amendment of Statement 133 on Derivative
Instruments and Hedging Activities (May 2002). See Attachment 1 for
News Release, FASB Exposure Draft Amends Definition of a Derivative and
Statement 133 to Provide for More Consistent Accounting (May 1, 2002).
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Issuance of a proposal that would increase the consistency of
reporting for acquisitions of financial
institutions.4
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\4\ See Exposure Draft, Acquisitions of Certain Financial
Institutions (May 2002). See Attachment 1 for News Release, FASB
Publishes Exposure Draft, Acquisitions of Certain Financial
Institutions, That Amends Statements 72, 144 and Interpretation 9 (May
13, 2002).
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Issuance of a proposal that would improve the disclosure of
guarantees (see below the discussion, ``What Are the Board's
Current Projects to Improve the Transparency of Financial
Reports?'').5
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\5\ See Exposure Draft, Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness of Others (May 2002). See Attachment 1 for News Release,
FASB Issues Exposure Draft That Expands Disclosure Requirements for
Guarantees (May 22, 2002).
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Pending issuance (in early July) of a standard that will
improve the transparency of costs associated with disposal
activities.
Pending issuance (in early July) of a proposal that would
resolve problems encountered in present practice relating to
the consolidation of special-purpose entities (``SPEs'') (see
below the discussion, ``What Are the Board's Current Projects
to Improve the Transparency of Financial Reports?'').
what is the financial accounting foundation (``faf''), and what is the
faf's relationship to the fasb?
The FASB is an operating unit of the Financial Accounting
Foundation (``FAF''). The FAF is a not-for-profit foundation that was
incorporated in 1973 to operate exclusively for charitable,
educational, scientific, and literary purposes within the meaning of
Section 501(c)(3) of the Internal Revenue Code.
The FAF is separate from all other organizations. Its 16-member
Board of Trustees is composed of prominent individuals with a broad
range of backgrounds. Each of them shares a common understanding of the
importance of independent private-sector accounting standard setting to
the efficiency of the US capital markets.6
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\6\ See Attachment 2 for a list of the current FAF Trustees.
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The FAF Trustees have several important responsibilities with
respect to the FASB.
Those responsibilities include:
1. Oversight of the FASB's process to ensure that the FASB is
fulfilling its stated mission (see below the discussion, ``What
Process Does the FASB Follow in Developing Accounting
Standards?'')
2. Selection of the FASB Board members
3. Arranging for the financing of the FASB.
FAF Trustees select the FASB Board members based on their technical
expertise in financial accounting and reporting. Board members,
however, have diverse backgrounds. Of the seven current members of the
Board, three are from the accounting profession, two from the business
community, one from the analyst community, and one from the academic
community.
Each of the Board members is a full-time employee of the FAF and is
required to be independent of all other business and professional
organizations. Thus, upon joining the FASB, Board members are required
to sever all financial ties with former employers. Board members can
serve no more than two full five-year terms.
Approximately two-thirds ($15 million in 2001) of the FASB's
financing results from the public sale and licensing of the FASB's
publications. The remaining one-third ($6 million in 2001) results from
the fundraising efforts of the FAF Trustees who solicit donations from
a broad range of consumers, preparers, and auditors of financial
reports.
To ensure the independence and objectivity of the FASB, the Board
members are prohibited from participating in the FAF Trustees'
fundraising efforts, and the FAF Trustees are prohibited from
participating in the Board members' technical decisions on establishing
and improving accounting standards.
In recent months some have raised questions about the funding of
the FASB and the potential impact of the current funding structure on
the appearance of the Board's independence. In my five years as
Chairman of the FASB, no contribution to the FAF, or threat of
withholding a contribution, if any occurred, had any impact, in any
way, on any of the decisions of the Board. The FAF Trustees and the
FASB remain confident that the FAF's current funding structure
sufficiently insulates the Board from any possible influence from
funding sources.
The FASB, however, has expressed support for recent efforts by
Congress to develop a secure and adequate non-discretionary funding
source for the FAF that might serve to strengthen the appearance of
independence of the FASB.7 The FAF and the FASB stand ready
to work constructively with Congress, including the Subcommittee, and
the SEC to attempt to develop such a funding structure. It is
essential, however, that any such structure be designed with care in
order to avoid substantive conditions and governmental control that
would invite political interference with the Board's decisions, and
consequently weaken, rather the strengthen, both the reality and
appearance of the Board's independence.
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\7\ See Attachment 1 for News Release, FASB Chairman Comments on
Proposed Legislation (March 19, 2002).
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what process does the fasb follow in developing accounting standards?
Because the actions of the FASB affect so many organizations and
are so important to the efficient functioning of the US capital
markets, its decision-making process must be open and thorough. An open
and thorough process is essential to ensuring the credibility and
quality of the resulting standards. An open and thorough process also
reduces the possibility that standards will create unintended
consequences inconsistent with transparent financial reporting.
Our Rules of Procedure require an extensive and public due process
that is broader and more open in several ways than the Federal
Administrative Procedure Act, on which it was modeled. The FASB process
involves public meetings, public hearings, field tests, and exposure of
our proposed standards to external scrutiny and public comment. The
Board makes final decisions only after carefully considering and
understanding the views of all parties, including consumers, preparers,
and auditors of financial information.
The FASB and the FAF, in consultation with the Board's
constituents, periodically review the FASB's due process to ensure that
the process is working efficiently and effectively. Beginning in
January of this year, in response to constituent requests, including
requests from our Financial Accounting Standards Advisory Council,
8 the FAF and FASB have undertaken several actions to
improve the Board's due process procedures, as well as improve the ease
of access to our standards and related accounting literature, reduce
the complexity of our standards, and modernize financial accounting and
reporting.
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\8\ See Attachment 3 for information about the Financial Accounting
Standards Advisory Council.
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Those actions include the following:
Reducing the Board voting requirement from a 5-to-2
supermajority to a 4-to-3 majority to make the process more
efficient without compromising the quality of the FASB's
standard-setting process.9
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\9\ See Attachment 1 for News Release, Financial Accounting
Foundation Changes Financial Accounting Standards Board's Voting to
Increase Efficiency (April 24, 2002).
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Reorganizing the FASB's research and technical activities
staff by reallocating the staff functions across three distinct
areas versus one that had previously been in place. The
reorganization is designed to address increasing demands on
staff and other resources of the FASB.10
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\10\ Ibid.
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Implementing an improved approach to determining what new
major topics should be added to the FASB's technical agenda.
That approach involves issuing a proposal for public comment
before the Board decides whether to add a particular project to
its agenda. The proposal discusses the problem to be addressed
(that is, the reason for the project), the proposed scope,
relationship to the conceptual framework and relevant research,
the main issues and alternatives the Board expects to consider,
and how practice might be affected. The proposal also
explicitly reviews the Board's agenda decision
criteria.11 The Board believes this improved
approach provides additional discipline to the Board's project
management capabilities, particularly in the area of defining
and refining the scope of a new agenda project. Scope expansion
during the life of a project has sometimes been a significant
impediment to the timeliness of the Board's standard setting.
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\11\ See Attachment 2 for information about the Board's agenda
criteria.
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Implementing a more rigorous project planning and management
process, which requires the establishment of clear project
milestones and plans for meeting them, resource budgets, and
status reporting in terms of previously established milestones.
Working with the Emerging Issues Task Force
(``EITF''),12 the American Institute of Certified
Public Accountants, and the SEC to more clearly define and
coordinate their accounting-standard-setting roles with those
of the FASB with an eye toward streamlining certain activities.
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\12\ See Attachment 2 for information about the EITF.
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Making it easier for constituents to find all of the
appropriate accounting requirements for a particular topic by
including references to all applicable US accounting literature
in the FASB's future standards and in the FASB's Current Text,
a compilation of all FASB accounting standards categorized by
subject. In addition, the FASB is seeking to partner with
others in developing an online database that will include all
of the US accounting literature.
Reducing the complexity of accounting literature by (1)
seeking to determine if the FASB can issue standards that are
less detailed and have few, if any, exceptions or alternatives
and (2) more actively engaging FASB constituents in discussions
about the cost-benefit relationship of proposed standards.
Working with the SEC in its initiative to modernize financial
reporting and disclosure.
Finally, in addition to the above actions, the FAF Trustees have
asked my successor, newly named FASB Chairman Robert H. Herz, after he
has assumed his new post on July 1, 2002, to review the FASB's
operations and make additional recommendations for
improvements.13
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\13\ See Attachment 1 for News Release, Financial Accounting
Foundation Changes Financial Accounting Standards Board's Voting to
Increase Efficiency (April 24, 2002).
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what are the board's current projects to improve the transparency of
financial reports?
The FASB has 18 current agenda projects designed to improve the
transparency of financial reports.14 A brief description of
six of the more significant of those projects follows:
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\14\ See Attachment 4 for a list and detailed description of the
FASB's agenda projects.
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Interpretative Guidance on Consolidation of SPEs
As evidenced by Enron, transactions involving SPEs are becoming
increasingly prevalent and complex. The complexity of their structure
makes it difficult to determine if another enterprise has a controlling
financial interest in the SPEs that would result, under existing
accounting requirements, in that other enterprise consolidating
(reporting the assets and liabilities of) the SPEs. Preparers of
financial reports, their auditors, and analysts and other users of
financial reports have indicated that additional guidance is needed for
determining when SPEs should be consolidated by another enterprise.
Since November 2001, the Board has been working with constituents
to develop, at public meetings, interpretative guidance that would
require that many SPEs that are currently not consolidated, be
consolidated by the enterprise they support. The interpretative
guidance would result in a more representationally faithful depiction
of enterprises' assets and liabilities.
The Board plans to issue proposed interpretative guidance in early
July.
Interpretative Guidance on Guarantees
The FASB has observed that there are differing practices about the
need for disclosures by enterprises, like Enron, that guarantee the
debt and other obligations of SPEs and other enterprises. The FASB has
also observed that there are differing practices about the need for the
guarantor enterprise to recognize an initial liability for its
obligation under the guarantee.
Since February 2002, the Board has been working with constituents
to develop, at public meetings, interpretative guidance that would
require that enterprises recognize a liability at fair value for the
obligations they undertake when issuing a guarantee, and that they
provide additional disclosures about the guarantee. The interpretative
guidance would result in a more representationally faithful depiction
of enterprises' assets and liabilities and improved transparency of
enterprises' obligations and liquidity risks related to guarantees
issued.
Last month the Board issued the proposed interpretative
guidance.15
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\15\ See Attachment 1 for News Release, FASB Issues Exposure Draft
That Expands Disclosure Requirements for Guarantees (May 22, 2002).
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Disclosures about Intangible Assets
For many enterprises, the amounts of intangible assets reflected in
their financial reports are very small. In a recent article in
Financial Executive (March/April 2002, p. 35), a prominent researcher
indicated that ``. . . in the late 1990s, the annual U.S. investment in
intangible assets--R&D, business processes and software, brand
enhancement, employee training, etc.--was roughly $1.0 trillion, almost
equal to the $1.2 trillion total investment of the manufacturing sector
in physical assets. Further, intangible capital currently constitutes
between one-half and two-thirds of corporate market value . . .'' The
FASB has observed that there is very little information--quantitative
or qualitative--about those intangible assets in financial reports.
In January 2002, the Board added a project to its agenda to expand
the disclosures required about intangible assets. The FASB Board and
staff are currently gathering additional information from constituents
to determine, at public meetings, what qualitative and quantitative
disclosures about intangible assets would be most relevant for
consumers.
The Board plans to issue a proposed standard in the fourth quarter
of this year.
Fair Value
In connection with its development of a standard on accounting for
derivative instruments and hedging activities, 16 the Board
observed that financial statements would be more useful and transparent
if all financial instruments were carried in the statement of financial
position at fair value. The Board, however, also acknowledged that
there were many difficult conceptual and practical issues that needed
to be resolved before that goal could be achieved. As the initial steps
in resolving those issues, the Board issued two preliminary documents
for public comment in December 1999 17 and December
2000.18
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\16\ See Statement FASB Statement No. 133, Accounting for
Derivative Instruments and Hedging Activities (June 1998).
\17\ See Preliminary Views, Reporting Financial Instruments and
Certain Related Assets and Liabilities at Fair Value (December 1999).
\18\ See Special Report, Financial Instruments and Similar Items
(December 2000).
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In November 2001, the Board reaffirmed its ultimate goal of
requiring essentially all financial assets and liabilities to be
measured at fair value in financial statements. The Board, however,
also determined that it should pursue an intermediate objective of
replacing the existing standard that requires that all financial
instruments be reported at fair value in the financial statement
footnotes.19 The proposed standard would describe more
specifically how to determine fair value for financial instruments and
improve the form and content of the footnote disclosures.
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\19\ See FASB Statement of Financial Accounting Standards No. 107,
Disclosures about Fair Value of Financial Instruments (December 1991).
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The Board plans to issue a proposed standard addressing the
intermediate objective next year.
Financial Performance Reporting by Business Enterprises
The FASB has observed that increased reporting of numerous and
inconsistent alternative (pro forma) financial measures has heightened
investor confusion and has raised significant questions about the
credibility of financial reporting.
In October 2001, the Board added a project to its agenda to (1)
improve the quality of information displayed in financial reports so
that consumers can better evaluate an enterprise's financial
performance and (2) ascertain that sufficient information is contained
in the financial reports to permit calculation of key financial
measures used by investors and creditors.
Since adding the project to the Board's agenda, the Board and its
staff have conducted a series of interviews with more than 50
individuals who use financial reports--investors, creditors, and their
advisors (equity and credit analysts)--to assist the FASB in
identifying key financial measures that they use in evaluating the
performance of an enterprise. A summary of the findings resulting from
those interviews is available on the FASB website. The FASB has
discussed the results of the user interviews with its project task
force of constituents. The FASB plans to coordinate the project with a
similar project being conducted jointly by the International Accounting
Standards Board (``IASB'') and the UK's Accounting Standards Board.
The Board has begun its public discussions of the project issues
and plans to issue a proposed standard next year.
Revenue Recognition
The FASB has observed that enterprises and auditors have
continually received and raised questions about revenue (and related
liability) recognition issues. In addition, recent studies on financial
reporting indicate that revenue recognition is the largest category of
fraudulent financial reporting and restatements of financial reports.
In May 2002, the Board decided to add a project on revenue
recognition to its technical agenda.20 As part of that
project, the Board will seek to eliminate inconsistencies in the
existing accounting literature and accepted practices, fill voids in
the guidance that have recently emerged, and provide further guidance
for addressing issues that arise in the future. The Board also decided
that, in the interim while the standard is being developed, the EITF
should continue to provide guidance on issues of revenue recognition
based on the existing authoritative literature.
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\20\ See Attachment 1 for News Release, FASB Adds Revenue
Recognition Project to Its Agenda (May 20, 2002).
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The Board plans to issue a proposed standard next year.
what are the fasb's views on the june 18, 2002, discussion draft of the
financial accounting standards board act?
The FASB understands and appreciates the important oversight role
of the Subcommittee. The FASB has fully cooperated with, and has been
responsive to, the requests of the Subcommittee in connection with
their development of the Discussion Draft. The FASB's comments on
earlier drafts of the Discussion Draft have emphasized the critical
importance of the FASB's independence and open and thorough due process
to the development of high-quality financial accounting and reporting
standards.
The FASB is supportive of the Discussion Draft's clear statements
on (1) the authority of FASB standards, and (2) the duty of the FASB in
Sec. 3 and Sec. 4, respectively. In addition, the FASB is supportive of
the (1) general principles for promulgating and revising standards, and
(2) objectives for conducting the FASB's activities in Sec. 5(a) and
Sec. 5(b), respectively. Those provisions contain language essentially
the same as language contained in the FASB's mission statement and
conceptual framework.21
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\21\ See Attachment 2 for information about the FASB's mission
statement and conceptual framework.
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As explained earlier in my testimony (see above the discussion,
``What is the FASB, What Does It Do, and What Has It Done Lately?''),
the FASB's authority and expertise does not extend to auditing or
ethical standards for the accounting profession. Thus, the FASB is not
the appropriate organization to promulgate the primary standard in Sec.
5(c) of the Discussion Draft. Similarly, the requirement in Sec.
7(2)(B) that the FASB transmit a report containing an evaluation of the
compliance of financial statements with accounting standards is beyond
the Board's scope of authority, and the cost of such an evaluation
would likely be far beyond the Board's limited resources.
The FASB also would have concerns about the Discussion Draft's
requirements in Sec. 5(d) mandating the development of standards
addressing certain specific issues, and in Sec. 5(e) mandating the
completion of certain projects on the FASB's current agenda within
specified time periods. Those provisions restrict the Board's ability
to make objective and unbiased decisions on technical matters and,
therefore, compromise the ability of the FASB to produce high-quality
standards.
The FASB's limited resources necessitate that we carefully
prioritize the projects and issues that we address and the specific
scope of those projects and issues. Mandating the development of
standards addressing certain specific issues inevitably means that the
FASB cannot develop standards addressing other specific issues that
might have a higher priority in terms of the needs of consumers.
Moreover, mandating completion of certain agenda projects within
specified time periods would likely shortcut the FASB's open due
process on those projects. In order to comply with the artificial
deadlines the resulting standards would likely have to be issued
without the benefit of a full opportunity for open input, discussion,
and analysis of constituent views.
Both mandates also would have an adverse impact on the FASB's goal
of converging financial accounting and reporting standards around the
world. To ensure convergence, the FASB, the IASB, and other national
accounting standard setters must have significant flexibility over our
respective agendas and the timing of projects so that common projects
and issues can be addressed concurrently.
Finally, the FASB also would have concerns that mandating the
development of standards addressing certain specific issues would
create a dangerous precedent. For example, the provisions could lead to
future Congressional or governmental mandates that certain specific
accounting issues not be addressed--a clear threat to the FASB's
independence.
The FASB would not oppose the Discussion Draft's provisions to
transmit reports containing an assessment of the FASB's resources, or
the progress made on the projects included on the FASB's technical
agenda in Sec. 7(a)(2)(A) and Sec. 7(a)(2)(C), respectively. Of note,
the required contents of the report of the General Accounting Office in
Sec. 7(b) appears to be redundant to the responsibilities currently
carried out by the FAF. More specifically, the required assessment of
the independence of the FASB, and the evaluation of the procedures
followed by the FASB in Sec. 7(b)(2)(B) and Sec. 7(b)(2)(C),
respectively, might be more appropriately included in the required
report of the FASB in Sec. 7(a)(1).
My five years as Chairman of the FASB has reaffirmed my opinion,
shared by most of our constituents, including, I believe, by most
Members of Congress, that resolution of accounting issues in an
independent and objective manner is absolutely essential to maintaining
and enhancing the highest quality standards in the world.
The standards developed by the FASB for over the past quarter
century have provided the backbone for our nation's vibrant capital
markets because of the transparent, credible, and reliable nature of
the information that results from their proper application. Those
standards can, and should, be improved. Those standards, however, for
the reasons stated above, would not be improved by the enactment of
certain provisions contained in the Discussion Draft. Those provisions
would impair both the reality and the appearance of the FASB's
independence. Thus, the Discussion Draft could have both a short and
long-term negative impact upon the credibility and quality of financial
information and, consequently, on the longstanding competitive
advantage that, even under the current environment, US capital markets
continue to enjoy.
did enron's financial statements comply with existing gaap?
22
---------------------------------------------------------------------------
\22\ See Attachment 5 for The FASB's Role in Serving the Public, A
Response to the Enron Collapse, By Edmund L. Jenkins, Chairman,
Financial Accounting Standards Board (2002).
---------------------------------------------------------------------------
Enron publicly acknowledged in its November 8, 2001, Form 8-K and
November 19, 2001, Form 10-Q filings with the SEC that it had failed to
comply with existing accounting requirements in at least two areas.
First, Enron indicated that with respect to four SPEs that it created
during 2000, it issued Enron common stock to the SPEs in exchange for
notes receivable from the SPEs. At the time, Enron reported an increase
in assets and shareholder's equity to reflect those transactions.
Longstanding accounting requirements, however, provide that notes
receivable arising from transactions involving an entity's own capital
stock are generally required to be reported as deductions from
stockholders' equity and not as assets.23
---------------------------------------------------------------------------
\23\ See EITF Issue No. 85-1, ``Classifying Notes Received for
Capital Stock,'' and SEC Staff Accounting Bulletin No. 40, Topic 4-E,
Receivables from Sale of Stock.
---------------------------------------------------------------------------
As a result of this error, Enron indicated that it had overstated
both total assets and shareholders' equity in its financial statements
for the second and third quarters of 2000, and its annual financial
statements for 2000, by $172 million. It also indicated that it had
overstated both total assets and shareholders' equity in its financial
statements for the first and second quarters of 2001 by $1.0 billion.
Second, Enron indicated that the assets, liabilities, gains, and
losses of three previously unconsolidated SPEs should have been
included in Enron's financial statements under existing accounting
requirements. As a result of that error, Enron indicated that it had
overstated reported net income by approximately $96 million in 1997,
$113 million in 1998, $250 million in 1999, and $132 million in 2000.
It also indicated that it had understated net income by $17 million and
$5 million in the first and second quarters of 2001, respectively, and
overstated net income by $17 million in the third quarter of 2001.
Finally, Enron indicated that as a result of this error, it also had
understated debt (or liabilities) by approximately $711 million in
1997, $561 million in 1998, $685 million in 1999, and $628 million in
2000.
In commenting on Enron's restatements in testimony before Congress,
former SEC Chief Accountant Lynn Turner stated:
New accounting rules were not needed to prevent the
restatements of Enron's financial statements or improve the
quality of some of its disclosures. Compliance with and
enforcement of the accounting rules that have been on the books
for years would have given investors a timely and more
transparent picture of the trouble the company was
in.24
---------------------------------------------------------------------------
\24\ Written statement by Lynn Turner in testimony before the
Committee on Governmental Affairs, United States Senate (January 24,
2002), page 3.
---------------------------------------------------------------------------
In February 2002, a committee of three outside members of Enron's
own board of directors filed a public report (``Powers Report'') that
stated that its investigation ``identified significant problems beyond
those Enron has already disclosed.'' 25
---------------------------------------------------------------------------
\25\ William C. Powers, Jr., Chair, Raymond S. Troubh, and Herbert
S. Winokur, Jr., Report of Investigation by the Special Investigative
Committee of the Board of Directors of Enron Corp. (February 1, 2002),
page--3.
---------------------------------------------------------------------------
Those further problems included entering into transactions that
Enron
could not, or would not, do with unrelated commercial entities.
Many of the most significant transactions apparently were
designed to accomplish favorable financial statement results,
not to achieve bona fide economic objectives or to transfer
risk. Some transactions were designed so that, had they
followed applicable accounting rules, Enron could have kept
assets and liabilities (especially debt) off its balance sheet;
but the transactions did not follow those rules.26
---------------------------------------------------------------------------
\26\ Ibid., page 4.
---------------------------------------------------------------------------
The Powers Report suggests that ``other transactions'' resulted in
``Enron reporting earnings from the third quarter of 2000 through the
third quarter of 2001 that were almost $1 billion higher than should
have been reported.'' 27
---------------------------------------------------------------------------
\27\ Ibid.
---------------------------------------------------------------------------
The Powers Report also states that Enron's disclosures about its
transactions with the partnerships were ``obtuse, did not communicate
the essence of the transactions completely or clearly, and failed to
convey the substance of what was going on between Enron and the
partnerships.'' 28
---------------------------------------------------------------------------
\28\ Ibid., page 17. See Attachment 6 for additional excerpts from
the Powers Report on Enron's failure to follow existing accounting
requirements.
---------------------------------------------------------------------------
More recently, Enron publicly acknowledged in its April 22, 2002,
Form 8-K with the SEC that it may have failed to comply with existing
accounting requirements relating to the ``valuations of several assets
the historical carrying value of which current management believes may
have been overstated due to possible accounting errors or
irregularities.'' 29 The 8-K indicates that the amount of
the overstatement may be in the billions of dollars.
---------------------------------------------------------------------------
\29\ Enron Corp., Form 8-K (April 22, 2002), page 2.
---------------------------------------------------------------------------
Finally, in connection with the federal government's recently
completed trial of Andersen in Houston, Texas, partners from Andersen's
professional standards group testified that ``seriously flawed
accounting methods and misleading documentation [was] prepared by the
Enron team to justify the accounting.'' 30 They also
testified that the Enron audit team ``disregarded and misrepresented''
the professional standards group's advice about the appropriate
accounting required.31
---------------------------------------------------------------------------
\30\ Susan Schmidt, ``Tensions Flare at Trial of Andersen: Enron
Auditors Said to Have Ignored Advice,'' The Washington Post (May 10,
2002), page E4.
\31\ Ibid., page E1.
---------------------------------------------------------------------------
conclusion
During my five years as Chairman of the FASB, on two different
occasions in which the FASB was proposing major improvements to the
transparency of financial reports, several Members of Congress either
introduced, or threatened to introduce, legislation. The legislation,
if enacted, would have, at a minimum, significantly delayed the needed
improvements the FASB was proposing. In other cases, the legislation,
if enacted, would have essentially eviscerated the FASB.
On both occasions the FASB, with the support of many constituents,
including consumers, and Members of this Subcommittee, successfully
responded to those challenges, and final standards were issued that
dramatically improved the transparency of financial reports. Responding
to those challenges, however, diverted some of the limited resources of
the FASB; resources that otherwise would have been devoted to the
FASB's primary mission of improving accounting standards to protect
consumers. 1Thus, my experience as Chairman of the FASB, has led me to
conclude that the most effective way this Subcommittee and individual
Members of Congress can promote the timeliness and efficiency of the
FASB, the quality of accounting standards, and the transparency of
financial reports, is simply to permit the FASB to do its job. Members
of Congress must reject the facile arguments and emotional appeals
sometimes made by constituents claiming that FASB proposals will
destroy Western civilization. Over 60 years of history conclusively
demonstrate that accounting standards that result in more transparent
financial reporting enhance, rather than hinder, the US economy.
I am very confident that my successor, Bob Herz, will demonstrate
to the Subcommittee, and all who participate in the capital markets,
that he has the leadership and technical skills necessary to ensure
that the FASB continues to provide the markets with higher quality
accounting standards that will result in more transparent and credible
financial reports in the months and years ahead.
Thank you again, Mr. Chairman. I very much appreciate your interest
in, and support of, the independence of the FASB. I also want to thank
you Mr. Chairman, Ranking Member Towns, and all of the Members of the
Subcommittee for the personal support you have graciously provided to
me over the past five years.
I would be happy to respond to any questions.
Mr. Stearns. I thank you.
Mr. Dharan.
STATEMENT OF BALA G. DHARAN
Mr. Dharan. Chairman Stearns, Ranking Member Towns, and
members of the subcommittee, I am honored to be given this
opportunity to testify here today.
I have submitted my written testimony and I will be
presenting here a brief overview of what is in the written
testimony.
Mr. Stearns. We can make your entire statement part of
record, if you like.
Mr. Dharan. Thank you.
Mr. Stearns. By unanimous consent, so ordered.
Mr. Dharan. The proposed H.R. bill, the Financial
Accounting Standards Board Act, or as I am going to refer to
it, the draft bill, comes in the context of a crisis of trust
that several members have already mentioned that we see in the
financial markets. This crisis has been brought about by the
weakened credibility of the U.S. financial reporting system.
Restoring the credibility and strengthening the financial
reporting environment requires legislative and corporate action
on several fronts, including an improved corporate governance
process, having better accounting rules, stronger enforcement
of accounting rules, stronger oversight of independent auditors
and the auditing profession, stronger investor protection, and
so on.
But these steps would be incomplete unless we also use the
opportunity presented by the current crisis to examine ways to
strengthen our accounting standard-setting process.
We are, of course, starting from a strong base of well-
respected, well-functioning and independent standard setting
body, namely the FASB.
Nevertheless, the power of the FASB to set accounting
standards comes from a tenuous relationship between the SEC and
the FASB, starting with a historic and discretionary decision
by the SEC in the late 1930's to allow the private sector to
set accounting standards while retaining the power to overrule
them.
While the partnership between the SEC and the FASB has
shown to be fairly workable over the years, the fact that the
FASB has no independent legal basis affects the effective
functioning of the FASB in many practical ways.
For example, it was a critical factor, in my judgment, in
the FASB's lost battles of stock option accounting during the
1990's.
Thus, any legislation to strengthen the standard-setting
process must start with an unambiguous show of support from
Congress for a strong and independent FASB by providing an
independent, legal basis for its existence. The proposed bill
goes in the right direction toward this goal.
Second, by proposing a path-breaking requirement that the
FASB issue a primary standard requiring adherence to
principles, this legislation takes the right step in moving the
standard-setting process in the United States toward a
principles-based approach, as opposed to the current approach
to issuing standards and interpretations of high specificity,
which has been described by critics as rules-based.
This part of the legislation is innovative.
Providing the FASB an independent legal basis for existence
and moving the standard-setting process toward a principles-
based approach are the primary strengths of the bill. However,
trying to achieve these goals will also require addressing
several key implementation issues.
The foremost, and I think the most daunting implementation
issue is a clear delineation of the roles of the FASB and the
SEC in the development of accounting standards.
The second, and related, implementation issue is the
development of a viable, long-term funding mechanism for the
activities of the FASB.
Below, I am going to expand just a little bit on the two
key issues I mentioned just now.
The first one, strengthening the FASB's legal basis. The
rich history of the development of accounting standard setting
in the U.S. has been recounted elsewhere, and also I have
stated some references in my written testimony.
However, a brief review of the complex relationship that
exists between Congress, the SEC and the FASB here would help
eliminate the theme that the FASB in the standard-setting
process can benefit much from the granting of an independent
legal status for the FASB's existence.
The SEC has long accepted and encouraged the role of the
private sector, and specifically the FASB, in developing
accounting standards, starting with its Accounting Series
Release No. 4, which was issued in 1938.
While the FASB has generally received the open support of
the SEC to continue to set accounting standards, this support
has not been without problem. The SEC, after all, does have the
statutory power to overrule the FASB.
Business executives and others potentially affected by the
accounting standards, the constituents that Chairman Jenkins
referred to, are fully aware of this underlying weakness in the
power of the FASB.
The constituents of the FASB, in effect, know that the buck
does not stop here, and they can try to go around the FASB by
seeking intervention from the SEC or Congress whenever the FASB
ventures into areas of rulemaking that are detrimental to their
interests.
Further, the SEC and Congress have demonstrated, albeit
only rarely, their willingness to pressure the FASB to
reconsider its decisions for what might well be political
reasons rather than conceptual reasons. Again, in my written
testimony, I have given specific examples of this, especially
the stock option accounting.
In summary, despite the current working relation between
the SEC and the FASB, the lack of a strong legislative basis
for the FASB's existence will generally mean that the FASB will
always, in the long run, face the risk of being second-guessed
by regulators.
The main beneficial effect of the proposed bill or draft
bill would be that it would result in Congress putting into law
unequivocally what has been the official position of the SEC
since 1938.
The statement in Section 3 of the bill that the standards
of financial accounting and reporting promulgated by the FASB
shall be authoritative for the purpose of determining
compliance with generally accepted accounting principles
essentially codifies in almost exact language what is already
present in the SEC's Financial Reporting Release Number 1 and
formerly Accounting Series Release Number 150.
It seems clear that this elevation of the FASB's current
role as stated in the SEC's rules into an independent
legislative fact will help considerably strengthen the FASB and
consequently the standard-setting process.
Let me answer and very briefly talk about the principles-
based standards. A surprising provision in the bill is the
section titled ``Primary Standard Requiring Adherence to
Principles'' in Section 5. This provision requires the FASB to
promulgate a primary standard requiring the application of
general principles.
The principles listed here are not new. In fact, they are
identical to what the FASB has already proclaimed as its
guiding principles in its Statement of Financial Accounting
Concepts Number 1.
So one might ask: if the bill essentially codifies what is
already in the FASB's Concepts Statement Number 1 and other
concept statements, what exactly is new in this bill?
Surprisingly, the newness is contained in the additional
requirement in the section that the primary standard should not
be violated even if a company can claim that it has followed
the letter of all other standards.
One could, thus, interpret the requirement of the proposed
bill as a new responsibility requirement for corporations to
ensure that their financial reports are not misleading to
investors, regardless of whether they have technically followed
all the other rules of the FASB.
Both the FASB, which conducted the conceptual framework
project in the 1970's to create the concept statements, and
more recently the International Accounting Standards Board, or
the IASB, have generally been in favor of issuing principles-
based standards.
In my written testimony, I have given quotations from the
IASB to support this also.
This bill makes such a process both mandatory for the FASB
and, additionally, requires regulatory compliance by
corporations with the principles. The provision does raise
significant implementation questions, which I am going to talk
about next.
Providing a stable legal basis for the FASB's standard-
setting process raises the issue of whether a legislative
enactment of what is already in the SEC's rules will, in
effect, change the statutory powers of the SEC with respect to
standard setting. I will leave the discussion of this issue to
others on the panel having expertise in legal matters such as
this.
But it is at least clear to me that the bill needs to
include an explicit reconciliation of the SEC's statutory
authority with the new provision and a statement of how the
FASB's standards would be enforced.
The potential implementation problem is that the SEC has
the statutory authority to both set and enforce standards,
whereas the FASB, under this new bill, will only have authority
to set accounting standards.
There is a possibility, then, that the SEC and the FASB may
both set standards which might potentially be in conflict, with
only the SEC having the power to enforce those standards.
A second major implementation issue is whether the FASB
will have the funds available to take on the responsibilities
set forth in the bill, especially the newly designated legal
standing for standard setting.
In particular, the bill requires the FASB to submit an
annual report to the President and to Congress, which may turn
out to be expensive to comply with because of a key provision
in the bill that the report should include an evaluation by the
FASB of the extent of compliance of all financial statements by
corporations.
Now, I personally support this requirement, since it only
means that the FASB needs to keep track of the compliance with
its own rules. However, the provision may require extensive and
continuous monitoring by the FASB of the corporate world's use
and abuses of financial reporting rules, which would be very
expensive to implement.
Considering these future commitments, it would be useful if
the bill includes a proposal, or proposals, for more stable and
independent funding plan for the FASB. The plan may well be
similar to what the SEC Chairman Harvey Pitt refers to as
``direct, involuntary and independent funding system.''
In the same testimony in Congress where the SEC Chairman
referred to this, he also referred to or specifically addressed
the funding of the FASB and called for ``involuntary funding
for the private-sector standard setter.'' In Chairman Pitt's
words, the funding ``should be more secure and should
strengthen both the reality and the appearance of independence.
Funding should be made involuntary.''
I fully support that statement.
Finally, when it comes to commenting on the current U.S.
accounting standard setting environment, it seems almost
mandatory for all speakers and writers to mention that we have
the best and the most trusted financial reporting system in the
world. Whether such a claim is true or not, it is a fact that
the Enron meltdown and the various accounting and reporting
scandals in the last few months have shaken investors' faith in
this claim and in our financial reporting system.
It is now time to fix the mess and restore investor
credibility in the financial reporting system.
This bill's proposal to codify the current SEC position on
the role of the FASB is a step in the right direction, and so
is its push to make the standard setters move toward a
principles-based standard.
However, the bill does raise significant and daunting
implementations issues and some new and poorly understood
conceptual issues as well. These issues need to be raised
effectively and discussed effectively as the bill moves forward
in your committee and Congress.
Thank you for the opportunity to present my views before
your committee. I will be glad to answer any questions.
[The prepared statement of Bala G. Dharan follows:]
Prepared Statement of Bala G. Dharan, J. Howard Creekmore Professor of
Management, Rice University
Chairman Stearns, Ranking Member Towns, and members of the
Subcommittee, I am honored to be given this opportunity to testify here
today.
The proposed H.R. Bill, the Financial Accounting Standards Board
Act (The draft Bill), comes in the context of a crisis of trust that we
see in the financial markets brought about by the weakened credibility
of the US financial reporting system. Restoring the credibility and
strengthening the financial reporting environment requires legislative
and corporate action on several fronts, such as improving the corporate
governance process, having better accounting rules, stronger
enforcement of accounting rules (including improved staffing and
funding of the Securities and Exchange Commission), stronger oversight
of independent accountants and the auditing profession (including the
creation of a new independent accounting board for enforcement),
improved education of managers about the need for transparency in
disclosures, stronger investor protection, and so on. But these steps
will be incomplete unless we also use the opportunity presented by the
current crisis to examine ways to strengthen our accounting standard-
setting process.
We are, of course, starting from a strong base of a well-respected,
well-functioning and independent standard setting body, namely the
Financial Accounting Standards Board. Nevertheless, the power of the
FASB to set accounting standards comes from a tenuous relationship
between the SEC and the FASB, starting with a historic and
discretionary decision by the SEC in the late 1930s to allow the
private sector to set accounting standards while retaining the legal
power to overrule them. While the partnership between the SEC and the
FASB has shown to be fairly workable over the years, the fact that the
FASB has no independent legal basis does affect the effective
functioning of the FASB in many practical ways. For example, it was a
critical factor in the FASB's lost battles of stock option accounting
during the 1990s. Second, it has led to a suboptimal private funding
mechanism in which the FASB is increasingly dependent on selling its
publications at high cost to fund itself. Thus, any legislation to
strengthen our standard-setting process must start with an unambiguous
show of support from Congress for a strong and independent FASB by
providing an independent, legal basis for its existence, followed by
solutions for its funding. The draft Bill is a step in the right
direction toward this goal. I provide additional discussion of this
issue below.
Secondly, by proposing a path-breaking requirement that the FASB
issue a ``primary standard requiring adherence to principles,'' this
legislation takes the right step in moving the standard-setting process
in the United States toward a ``principles-based'' approach, as opposed
to the current approach to issuing standards and interpretations of
high specificity, which has been described by critics as ``rules-
based''. This part of the legislation is innovative, and below I
discuss the financial engineering environment that has led to the
current plethora of complex accounting rules, and the advantages of
adopting a conceptual or principles-based standard setting approach
taken in this draft Bill.
Providing the FASB an independent legal basis for existence and
moving the standard-setting process toward a principles-based approach
are the primary strengths of the draft Bill. However, trying to achieve
these goals will also require addressing several key implementation
issues. The foremost, and most daunting, implementation issue is a
clear delineation of the roles of the FASB and the SEC in the
development of accounting standards. Since the SEC already has the
statutory authority (under the Securities Act and the Securities and
Exchange Act) to develop as well as enforce accounting standards, it
important for the draft Bill to include provisions that reconcile any
newly recognized statutory role of the FASB to issue accounting
standards with the powers already present in the SEC. The second, and
related, implementation issue is the development of a viable, long-term
funding mechanism for the activities of the FASB so that its current
dependence on selling its own rules to fund its operations is
eliminated. If the FASB were to have additional public responsibilities
to set accounting standards and periodically report to Congress on the
implementation of standards by corporations, then a funding plan to
execute these public responsibilities must be addressed as well. The
plan might be similar to the ``direct, involuntary and independent
funding'' system proposed by the SEC for its planned Public Accountancy
Board. Below I discuss in more detail what needs to be addressed in the
draft Bill to better help achieve its goals.
strengthening the fasb's legal basis
The rich history of the development of accounting standard setting
in the US has been recounted elsewhere.1 However, a brief
review of the complex relationship that exists between Congress, the
SEC and the FASB would help illustrate the theme that the FASB and the
standard-setting process can benefit much from the granting of an
independent legal basis for the FASB's existence.
---------------------------------------------------------------------------
\1\ For a good reference, one should start with the writings of my
colleague Professor Stephen A. Zeff of Rice University. I gratefully
acknowledge my discussions with him related to this testimony.
---------------------------------------------------------------------------
The SEC has long accepted and encouraged the role of the private
sector in developing accounting standards. In Accounting Series Release
No. 4 issued in 1938, the Commission stated its policy that financial
reports that followed accounting practices for which ``there was no
substantial authoritative support'' were presumed to be misleading.
After the formation of the FASB in 1973, the SEC has reaffirmed this
position and has stated in Accounting Series Release No. 150 (now part
of Financial Reporting Release No. 1) that ``principles, standards and
practices promulgated by the FASB in its Statements and Interpretations
will be considered by the Commission as having substantial
authoritative support, and those contrary to such FASB promulgations
will be considered to have no such support.'' 2 This view
has also been expressed frequently by SEC commissioners and accountants
in speeches and testimonies over the years.
---------------------------------------------------------------------------
\2\ Accounting Series Release No. 150, December 20, 1973; Financial
Reporting Release No. 1, 1982.
---------------------------------------------------------------------------
Without this strong and unwavering support from the SEC, there
would be no private sector standard setting and there would be no FASB.
This is because only the SEC has the statutory power to ensure that its
corporate registrants follow the accounting rules set forth by the
FASB. Thus, even if the SEC were to leave the standard setting activity
completely in the hands of the FASB subject to its oversight, the
effectiveness of the FASB to develop accounting standards depends on
the willingness of the SEC to enforce the resulting standards.
While the FASB has generally received the open support of the SEC
to continue to set accounting standards, this support has not been
without problems. The SEC, after all, does have the statutory power to
overrule the FASB, and not surprisingly, business executives and others
potentially affected by accounting standards (sometimes referred to as
the constituents of the FASB) are fully aware of this underlying
weakness in the power of the FASB. The constituents of the FASB, in
effect, know that ``the buck doesn't stop here,'' and so they try to go
around the FASB by seeking intervention from the SEC or Congress
whenever the FASB ventures into areas of rule making that are
detrimental to their interests. Further, the SEC and Congress have
demonstrated, albeit only rarely, their willingness to pressure the
FASB to reconsider its decisions for what might well be political
reasons rather than conceptual reasons.
The most glaring example of such an intervention was with respect
to FASB's project on stock options accounting, when the US Senate
passed a non-binding resolution in opposition to the FASB's position
that the cost of stock options should be shown by corporations as an
expense.3 Responding to efforts in Congress to overturn the
FASB's accounting rule, SEC effectively advised the FASB to shelve its
accounting rule requiring the expensing of stock options in favor of a
weaker rule requiring just footnote disclosures. The then SEC Chairman,
Mr. Arthur Levitt, described the SEC's role in this episode in a recent
media interview as follows: ``My concern was that if Congress put
through a law that muzzled FASB, that would kill independent standard
setting. So I went to FASB at that time, and I urged them not to go
ahead with the rule proposal. It was probably the single biggest
mistake I made in my years at the SEC . . .'' 4
---------------------------------------------------------------------------
\3\ For a history of this resolution See Stephen A. Zeff, ``The
U.S. Senate Votes on Accounting for Stock Options,'' in Stephen A. Zeff
and Bala G. Dharan, Readings and Notes on Financial Accounting, pp.
507-517 (McGraw-Hill, 1997).
\4\ See interview with Levitt in ``Bigger than Enron'', Frontline,
PBS, June 22, 2002. For excerpts, see http://www.pbs.org/wgbh/pages/
frontline/shows/regulation/congress/
---------------------------------------------------------------------------
There were other, more frequent, cases of regulatory interventions
during the earlier period of the FASB, such as the oil and gas
accounting controversy in the 1970s and the inflation accounting
controversy in the 1980s. It is true that these early episodes quickly
led to a more stable and functioning arrangement in which the SEC has
evolved into an ever-present and influential behind-the-doors partner
during the standard-setting process. The SEC actively participates
during the discussions that lead to major standards, and also
participates in the meetings of the Emerging Issues Task Force.
Despite the current working relationship, the lack of a strong
legislative basis for the FASB's existence will generally mean that the
FASB would always face the risk of being second-guessed by regulators.
The main beneficial effect of the draft Bill would be that it would
result in Congress putting into law unequivocally what has been the
official position of the SEC since 1938. The statement in section 3 of
the draft Bill, that the ``standards of financial accounting and
reporting promulgated by the FASB shall be authoritative for the
purpose of determining compliance with generally accepted accounting
principles by any person under any Federal regulatory program,''
essentially codifies in almost exact language what is already present
in SEC's Financial Reporting Release No. 1 and formerly Accounting
Series Release No. 150.5 It seems clear that this elevation
of the FASB's role as stated in SEC's FRR No. 1 into an independent
legislative fact would help considerably strengthen the FASB and
consequently its standard-setting process.
---------------------------------------------------------------------------
\5\ See my earlier quote for the exact language from the SEC's FRR
1.
---------------------------------------------------------------------------
principles-based standards
A surprising provision in the draft Bill is in section 5 subsection
(c), titled ``Primary Standard Requiring Adherence to Principles.''
This provision requires the FASB to promulgate a ``primary standard
requiring the application of the principles articulated in subsection
(a) of this section to financial accounting and reporting.'' In turn,
subsection (a), titled ``General Principles'', calls for the FASB to
follow certain principles when promulgating its standards. The
principles listed here are identical to what the FASB already has
proclaimed as its guiding principles in its Statement of Financial
Accounting Concepts No. 1.6 In essence, the ``objectives of
financial reporting'' of the FASB Concepts Statement No. 1 require that
financial reports should provide information that is useful to
investors and other users in making rational investment, credit, and
similar decisions.'' The draft Bill codifies this and the related
objectives of Concepts Statement No. 1.
---------------------------------------------------------------------------
\6\ Statement of Concepts No. 1, ``Objectives of Financial
Reporting by Business Enterprises,'' FASB, November 1978. This
Statement and six others issued by the FASB resulted from a
comprehensive ``Conceptual Framework'' project undertaken by the FASB
upon its inception. See the text below for additional discussion.
---------------------------------------------------------------------------
So one might ask: if the draft Bill essentially codifies what is
already in the FASB's Concepts Statements, what exactly is new in
section 5 (c)? Surprisingly the newness is contained in the additional
requirement in the section: ``Except as provided in paragraph (2), such
primary standard shall prohibit the application of any other standard
of financial accounting and reporting promulgated by the FASB in a
manner, or with a result, that fails to comply with such principles.''
In essence, this provision says that a company's financial reports must
be prepared in such a way that the ``primary standard'' of providing
information that is useful and comprehensible to investors should be
paramount, and should not be violated even if the company can claim
that it has followed the letter of all other standards. One could thus
interpret the requirement of section 5 (c) as a new responsibility
requirement for corporations to ensure that their financial reports are
not misleading to investors, regardless of whether they have
technically followed all the other rules of the FASB.
The provision also can be interpreted to impose a new standard for
the FASB to follow as it makes new accounting standards--namely that
such standards should not violate the primary standard. However, a
history of the development of the Concepts Statement No. 1 would show
that the FASB itself had always treated the various Concepts Statements
as similar guides. The Concept Statement No. 1 and six other related
Concepts Statements resulted from a so-called Conceptual Framework
project undertaken by the FASB soon after its inception in 1973. The
project was supposed to help the FASB develop a unified framework of
financial reporting that can guide its subsequent standard-setting
efforts and provide a measure of theoretical consistency to the
resulting standards.
The FASB's Conceptual Framework project was the first such major
effort by any standard setter to develop a principles-based standard-
setting process. More recently, the International Accounting Standards
Board (IASB) has generally expressed an interest in following a
principles-based approach to standard setting. For example, Sir David
Tweedie, Chairman of the IASB, spoke favorably of a principles-based
approach in a testimony to the US Senate on February 14, 2002, as
follows: 7 ``Both international standards and U.S. GAAP
strive to be principles-based, in that they both look to a body of
accounting concepts. U.S. GAAP tends, on the whole, to be more specific
in its requirements and includes much more detailed implementation
guidance . . .'' Chairman Tweedie went on to state his view of how the
IASB would set accounting standards: 8
---------------------------------------------------------------------------
\7\ Prepared testimony of Sir David Tweedie, Chairman of
International Accounting Standards Board, to US Senate Committee on
Banking, Housing, and Urban Affairs, February 14, 2002.
\8\ Ibid.
---------------------------------------------------------------------------
``The IASB has concluded that a body of detailed guidance
(sometimes referred to as bright lines) encourages a rule-book
mentality of ``where does it say I can't do this?'' We take the
view that this is counter-productive and helps those who are
intent on finding ways around standards more than it helps
those seeking to apply standards in a way that gives useful
information.--We [instead] favour an approach that requires the
company and its auditor to take a step back and consider
whether the accounting suggested is consistent with the
underlying principle.--Our approach requires a strong
commitment from preparers to financial statements that provide
a faithful representation of all transactions and a strong
commitment from auditors to resist client pressures.''
While the FASB and the IASB both seem committed to issuing
principles-based standards, this draft Bill makes such a process both
mandatory for the FASB and additionally requires regulatory compliance
by corporations with the principles. The provision does raise
significant implementation questions, since the burden of monitoring
compliance with the provision and of making sure that financial
statements follow the new primary standard would presumably fall on
external auditors and the SEC. Given the lack of adequate public
discussion in the US about what a principles-based approach would mean
for standard setting or for enforcement, my belief is that these
provisions of the draft Bill, while innovative, will require further
deliberations by the Subcommittee as to its enforcement and funding
implications.
implementation issues
Providing a stable legal basis for the FASB's standard-setting
process raises the issue of whether a legislative enactment of what is
already in the SEC's FRR No. 1 will in effect change the statutory
powers of the SEC with respect to standard setting. I will leave
discussion of this issue to others having expertise in legal matters
such as this, though it is at least clear to me that the draft Bill
needs to include an explicit reconciliation of the SEC's statutory
authority with the new provision, and a statement of how the FASB's
standards would be enforced. The potential implementation problem is
that the SEC has the statutory authority (under the Securities Act and
the Securities and Exchange Act) to set and enforce accounting
standards, while the draft Bill additionally recognizes the role of the
FASB in setting accounting standards. There is the possibility, then,
of both the SEC and the FASB setting standards which might potentially
be in conflict, with only the SEC having the power to enforce
standards. Hence the draft Bill needs to set forth a clear, functioning
structure that can guide the working relation between the FASB and the
SEC.
A second major implementation issue is whether the FASB will have
the funds available to take on the responsibilities set forth in the
draft Bill, especially if the newly designated legal standing for
standard setting leads to increased standard-setting responsibilities.
In addition, the draft Bill requires the FASB to provide an annual
report to the President and to Congress, which may turn out to be
expensive to comply with because of a key provision in the draft Bill
that the report should include ``an evaluation by the FASB of the
extent of the compliance of financial statements'' by corporations.
This provision may well require extensive and continuous monitoring by
the FASB of the corporate world's use and abuses of financial reporting
rules--similar to what is currently done by hundreds of staff members
at the SEC's Corporation Finance Division.
The development of a viable, long-term funding mechanism for the
activities of the FASB is certainly an issue that merits discussion
because the current operating budget of the FASB comes mainly from two
sources. According to the 2001 Annual Report of the Financial
Accounting Foundation (the parent organization of the FASB), the FASB
received $5.1 million in 2001 from ``net contributions'' from donors
and $14.8 million from ``subscription and publication sales.'' Netting
the ``direct cost of sales'' of these publications of $1.6 million, the
FASB received $13.2 million from the sale of subscriptions and
publications dealing with its accounting standards. This means that 72
percent of FASB's operating revenues in 2001 came from the sale of
publications describing or explaining its rules. The FASB may even need
to keep issuing new and more complex rules to keep the funds inflow
needed for its operations. The FAF 2001 annual report notes this
reality as well, and states that the revenue from publications is
``dependent upon the results of activities of the [Board's] technical
agendas.''
It would be useful if the draft Bill addresses this situation by
including proposals for a more stable and independent funding plan for
the FASB to execute its public responsibilities. The plan might be
similar to the ``direct, involuntary and independent funding'' system
proposed by the SEC Chairman Harvey Pitt, in a testimony to the US
Senate, for the SEC's planned Public Accountancy Board.9 In
the same testimony, Chairman Pitt also specifically addressed the
funding of the FASB and said that it ``should be more secure and should
strengthen both the reality and the appearance of independence. Funding
should be made involuntary.''
---------------------------------------------------------------------------
\9\ Prepared testimony of Harvey L. Pitt, Chairman of the SEC, to
US Senate Committee on Banking, Housing and Urban Affairs, March 21,
2002, Section 2.1.3.
---------------------------------------------------------------------------
conclusion
When it comes to commenting on the current US accounting standard
setting environment, it seems almost mandatory to mention that we have
the best and the most trusted financial reporting system in the world.
Whether such a claim is true or not, it is a fact that the Enron
meltdown and the various accounting reporting controversies that have
followed this year have shaken investors' faith in our financial
reporting system. It is now time to fix the mess and restore investor
credibility in the financial reports. While the SEC and Congress are
addressing needed changes in the areas of corporate governance,
investor protection, prosecution of management fraud, and regulation of
independent accountants, the issue of improving our financial standard-
setting process does need the attention of Congress as well.
The draft Bill's proposal to codify the current SEC position on the
role of the FASB in standard setting is a step in the right direction,
and so is its push to make the standard setters move toward principles-
based standards. However, these proposals do raise several daunting
implementation issues and some new conceptual issues as well. These
concerns need to be addressed effectively as the draft Bill moves
forward in your Committee and Congress. Thank you for the opportunity
to present my views before your Committee. I will be glad to answer any
questions from the Committee members.
Mr. Stearns. Thank you.
Professor Coffee.
STATEMENT OF JOHN C. COFFEE, JR.
Mr. Coffee. Thank you for inviting me here.
In light of WorldCom, investors and the market can only
mutter again and again Yogi Berra's famous phrase, ``It is deja
vu all over again.'' Why does this story keep repeating itself?
Now I cannot fully answer that question, but I can tell you
that it is likely to continue to reoccur with similar examples
unless two very different kinds of reforms are pursued.
The first is procedural reform, and both the House and the
Senate are zealously pursuing that course, admittedly on
somewhat different paths, but at least the issue is getting
fundamental attention.
This is the world of enforcement powers and closer
regulation of the accounting practitioner.
The other kind of reform that I think is at least as
necessary, is substantive reform, substantive reexamination of
GAAP accounting principles in light of Enron and similar
scandals. This has received far less attention and I would
applaud this committee for being the first committee in
Congress to clearly focus on it.
The basic point is this: even honest, zealous gatekeepers
can only measure compliance with the standard. And if that
standard is in some ways defective, or more likely ineffable
and open-ended, then there is going to be a failure in what the
gatekeeper can do.
My starting point here is that our current substantive
system of accounting principles, which is rule-based and quite
technical, has shown itself to be vulnerable, unacceptably
vulnerable, to exploitation by those who are willing to game
the system.
Now, it is certainly not FASB's responsibility that people
are gaming the system. And I clearly consider FASB to have been
over the last 20 years much more on the side of the angels. But
I think if we talk about reform, we have got to talk about how
we can establish a more principle-based system, rather than a
rule-based system of accounting, which is less vulnerable to
exploitation by those seeking to game the system.
I also believe that there is an emerging bipartisan
consensus on this point because both SEC Chairman Harvey Pitt
and his chief accountant have called for a more principled
system of accounting.
What that should focus us all on is what systems of
accounting today exist that appear to be more principled, and I
think it is usually the British system that is pointed to as
the exemplar of a more principled system of accounting. At the
end of my talk, I want to talk about one or two changes that
could be brought into the principles that you endorse in your
Section 5 or your proposed legislation.
Now, let us talk first about how do we get there toward a
more principled system of accounting, in terms of fundamental
steps. Here I speak not as an accountant--I am not one--but as
a law professor who specializes in governance. And we are
talking about a governance issue here, given the unique and
unparalleled complex relationship between FASB, the SEC, and
the accounting industry and the users and investors who rely on
certified financial statements.
The first point that I must make is that Congress cannot do
it itself. Congress cannot write technical accounting rules,
nor should it micro manage. And indeed, the intervention of
Congress in technical accounting rules has not always been
salutary. Sometimes things have been made worse.
What then can Congress do? The first thing I would say is
that it can assure the objectivity and independence of the
standard-setting process by giving FASB assured and independent
financing.
Today FASB, and this may be undiplomatic, but it is frankly
a somewhat low-budget operation that receives 2/3 of its
financing from the sale of its publications and is dependent
for the additional third of its financing on charitable
contributions that are made to its parent foundation, FAF, from
auditing firms and, in the language of the recent panel report
by the Panel on Auditing Effectiveness, from entities
interested in accounting principles.
Well, that is where the rub lies. Those interested in
accounting principles often have a perverse interest in
accounting principles. Enron and WorldCom are very interested
in accounting principles. And while FASB has resisted
pressures, I think it is an undesirable system to force FASB to
solicit financing from those who have a strong interest in the
standard-setting process.
Moreover, if additional duties are imposed on FASB, as this
legislation would do, the financing problem will become more
critical, and thus, I think you need to move to a system that
better assures FASB of independent financing.
I would suggest that the appropriate model here is the
National Association of Securities Dealers, which is the self-
regulatory body for the securities industry, and it basically
taxes the industry.
A tax system here is fairly simple to implement because you
could tax the auditing profession in terms of their
proportionate share of audited reports filed with the SEC, and
they, in turn, can pass that cost on to the corporate issuers
in their audit fees. That is step one, independent financing.
Step two, I think Congress can try to assure greater
openness and disclosure in the standard-setting process. With
Brandeis, I am a great believer in his statement that sunlight
is the best disinfectant and electricity the best policeman.
Not only should accounting principles be transparent, but
the process by which they are formulated could also use
somewhat more transparency.
As I described in my written statement, the most
controversial accounting rule to surface in the Enron saga was
the so-called 3 percent rule under which a special purpose
entity, or SPE, did not have to be consolidated with the
financial statements of its parent, if there were independent
investors who held a, ``controlling position'' and made a,
``substantial,'' equity investment.
Now FASB, itself, has never defined what is a substantial
independent investment, but its organ, the Emerging Issues Task
Force, EITF, has done so. And it defined a substantial
investment as 3 percent.
Frankly, if you were to leave this room and walk out on
Constitution Avenue and talk to investors, I think you would
find that the average investor would not agree that an entity
that owns 97 percent of another entity, which has a 3 percent
independent investment, was thereby independent of the parent.
I think you would get the view that 97 percent control is
virtually total control and there is not an independent
substantial investment.
Now my point here, the relevant point here is not the
particular rule, but it is that the EITF's procedures do not
permit public exposure of its draft documents. They are given
as authoritative opinions in response to a request for advice
and the process does not have what I think is the optimal level
of exposure or disclosure.
This private approach to policy formulation might have been
all right at a prior time when there was no controversy over
accounting rules, but frankly, those days are past.
Thus, I would submit that they should both be pre-issuance
exposure for public comment of all FASB interpretations,
including those of the EITF, and that there should be
consultation with the SEC, both over specific issues and over
the future agenda of FASB.
I believe the SEC should be able to at least place issues
on FASB's agenda and require, or request at least, a timely
response for critical issues. That would be the optimal
relationship between the SEC and FASB.
Now one more point about this 3 percent rule that I just
referred to. If you will look at the Powers Report, which is
the most authoritative document we have today, and it was done
after months of study by skillful, independent directors,
assisted by excellent counsel; the Powers Report could not
ultimately determine whether or not Arthur Andersen got it
right when it attempted to measure and when it did certify that
Enron had complied with the FASB pronunciations on off balance
sheet accounting.
We are not talking now about the violation of the 3 percent
rule. We are talking about the interpretation of that rule as
it applied to all of these SPE's.
They said there were a number of interpretative questions,
but they just could not tell. That tells us we may have a
problem in terms of the open-ended character of some critical
rules.
Now, here I come to my next point, timetables. As long as I
have been in this field, and that goes to well before the
creation of FASB, the whole topic of off balance sheet
accounting has been under review. It is likely to remain under
review if nothing else happens.
That is not really a criticism of FASB. And again I speak
as someone who is much more an admirer, than a critic of FASB.
It is rather because whenever rules in this area are
formulated, they are bound to gore someone's oxen.
And as a result, rather than have an adverse determination,
interest groups are going to pursue and prefer a dilatory
response as opposed to an adverse response. And there will be
interest groups that always want to delay the process. I think
it probably is desirable in that light for, on occasion,
particularly on critical occasions like the current environment
poses, for Congress to set some timetables.
Okay. Now last, I opened by talking about principle-based
accounting. I think there is an agreement in the country today
that we would like a more principled-based system of accounting
and certainly the SEC has advocated that.
Section 5(a) attempts to provide some general principles,
but I think that there is more content that could be put in
Section 5(a). I do not think it goes much beyond, as was just
pointed out, what FASB already says.
I think there could be a stronger endorsement of both the
concept of transparency and what I will call the British
concept of principled accounting. Basically, British
accountants must certify that the issuer's financial statements
provide a, ``true and fair view,'' of the issuer's overall
financial position.
Now this idea of fair presentation used to be there in U.S.
accounting principles, but it has been downsized over recent
decades into the far more limited certification which U.S.
auditors today provide with the issuer's financial statements,
``fairly present its financial position in accordance with
GAAP.''
It is not quite the strong statement that the British
require, that the financial statements provide a true and fair
view of the company's financial position. Personally, I
believe, that the auditors at Arthur Andersen, or any other of
the Big 5 firms, would have been more reluctant and more wary
about certifying the financial statements of an Enron if they
had to certify that these financial statements provide a, true
and fair view, or fairly present a holistic picture of the
company's financial position.
And I think you could make a statement, that is, at a
minimum, it would be useful if nothing else were done to
indicate and provide in Section 5(a) that the purpose of GAAP
is to provide a fair presentation of the issuer's financial
position that gives the investor an accurate and a holistic
sense of the issuer's financial position.
This is not micro managing, and I do not advocate micro
managing. But in terms of general principles of the kind that
you could announce in Section 5(a), I think you can put a
clearer statement in of the desirability that GAAP provide what
I will call a fair and holistic picture of the company's
overall financial position, not just that it has complied with
the rule book of 10,000 technical rules.
Those are my basic suggestions, and again, I am not trying
to address the specific accounting principles. I am trying to
address what I will call the governance picture of how FASB
should fit into this system.
Thank you.
[The prepared statement of John C. Coffee Jr. follows:]
Prepared Statement of John C. Coffee, Jr., Adolf A. Berle Professor of
Law, Columbia University Law School
i. introduction
In less than a month, between October 16, 2001 and November 8,
2001, Enron Corporation reduced its shareholders' equity by over $1.7
billion (roughly 18% of its previously reported equity of $9.6 billion
as of September 30, 2001) as the result of earnings restatements and
related adjustments. Less than a month later, on December 2, 2001,
Enron filed for bankruptcy protection under Chapter 11 of the United
States Bankruptcy Code in what was easily the largest U.S. corporate
bankruptcy.1 Correspondingly, Enron's common stock fell from
a high of approximately $90 per share in mid-2000 to under $1 per share
by the end of 2001; in short, a market capitalization of nearly $11
billion evaporated. Since that time, the U.S. Securities markets have
been traumatized (both by Enron and by the discovery that Enron was not
unique and that other companies--Adelphia, Tyco, Global Crossings and
others--were following similar accounting practices and policies). Many
firms, including unquestionably reputable companies, such as General
Electric, have seen their stock subjected to a ``transparency
discount'' as investors have learned to fear and distrust what they do
not fully understand from the face of the company's financial
statements.
---------------------------------------------------------------------------
\1\ Enron had reported assets of $63.4 billion on its bankruptcy,
thus easily beating Texaco, the second-largest bankruptcy, which filed
with assets of $35.9 billion.
---------------------------------------------------------------------------
Understandably and predictably, much fingerpointing has occurred
since Enron's fall, and much will continue. Reasonable people can
disagree, for example, about the appropriate reforms that are needed to
improve the regulation of the accounting profession, and not
surprisingly, quite different proposals are currently pending in the
House and Senate. But while reasonable (and sometimes even heated)
disagreement is possible on many questions, there should be consensus
on one fundamental point: our current substantive system of accounting
principles--rule-based and hypertechnical--has shown itself to be
vulnerable to exploitation by those willing to ``game'' the system.
Indeed, I believe there is already a bipartisan consensus on this need
for accounting principles that rest on a stronger and more principled
substantive foundation. Both SEC Chairman Harvey Pitt and the SEC Chief
Accountant Robert Herdman have expressed concerns that much of the
FASB's guidance is both too rule-based and too complex to be
comprehensible or useful to investors.2 They have further
suggested that the SEC needs to play a greater monitoring role with
regard to FASB projects on an ongoing basis and determine if any such
projects are needlessly languishing.3
---------------------------------------------------------------------------
\2\ See Letter dated May 3, 2002, from David M. Walker Comptroller
General of the United States to the Honorable Paul S. Sarbanes Chairman
Committee on Banking, Housing and ``Urban Affairs, United States Senate
(``GAO Report on Accounting Profession'') at pp. 9-10.
\3\ Id. at p. 10.
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Complex rules are by definition not transparent rules. This does
not mean that complexity can always be avoided, but it implies that
``procedural'' reforms that look only to whether the auditor has
faithfully complied with existing standards and honestly determined
that the client's financial statements are in comformity with
``generally accepted accounting principles'' (``GAAP'') are inherently
incomplete. Such ``procedural'' reforms (which term includes most of
the accounting reforms that have recently been proposed) are no doubt
important, but they will fail to have much real impact if the inventory
of GAAP principles remains so broad and open-ended that issuers can
find a GAAP principle to justify any desired result. Thus,
``substantive'' reform is necessary, which means that the content of
GAAP principles must be re-examined in light of Enron and related
crises. Of all the Committees of Congress currently considering Enron-
related reforms, this is the only committee to my knowledge to have
advanced this critical task to the point of legislation. Thus, if only
as a spectator on the sidelines, let me applaud your decision to focus
on this essential, if perhaps unglamorous task.
Still, it takes only a moment's reflection to recognize that
Congress cannot itself write accounting rules. The task is too
technical, and such rules need to be framed so as to be consistent with
the growing international convergence in accounting policies. Hence,
some independent, technocratic body must be delegated the task.
Conceivably, the SEC could handle this responsibility (and originally,
it did), but former SEC Chairman Arthur Levitt has convincingly argued
that to assign this task to the SEC would expose it to more political
pressure than it can safely handle. Hence, a more insulated body is
desirable. But to insulate any standards-drafting body from lobbying
pressures so that it can reach disinterested judgments requires as a
prerequisite that the body be given financial independence. If the
industry has control over the drafting body's funding, one can predict
that the threat to cut off funding will be used (perhaps subtly,
perhaps not). The troubled history of the Public Oversight Board, which
was the accounting industry's principal self-regulatory body in charge
of discipline, ethics and monitoring for the last twenty years until
this year (when its members resigned en masse), reveals this pattern
clearly.4 When the industry was displeased with the POB, it
turned down the funding spigot. As a partial result, the POB never came
close to fulfilling the role initially envisoned for it, even though it
was consistently staffed by first-rate and independent board members.
---------------------------------------------------------------------------
\4\ The history of the Public Oversight Board is briefly set forth
in the Report of the Panel on Audit Effectiveness, Report and
Recommendations, August 31, 2000 (``Panel on Audit Effectiveness
Report'').
---------------------------------------------------------------------------
In short, the first point to be made about the ``substantive''
reform of GAAP is that it is a process worth initiating only if the
drafting body undertaking that review is sufficiently independent of
the industry--both in terms of its members' conflicts and its financial
independence--that the outcome will not simply be the log-rolling
process by which budgets are passed in most legislative bodies. Since
1973, the SEC has delegated to the Financial Accounting Standards Board
(``FASB'') the primary responsibility for setting standards with
respect to the substantive accounting policies to be followed in the
preparation of financial statements in the private sector. FASB, as
part of the Financial Accounting Foundation (``FAF''), is ``a not-for-
profit organization which is supported by contributions from accounting
firms, corporations and other entities interested in accounting
issues.'' 5 The primary role of FASB's parent, FAF, is to
raise funds for FASB. Unfortunately, this uncertain funding structure
constantly places FASB and FAF in the role of a hat-in-hand supplicant
soliciting the industry for charity. Imagine what a large ``entity
interested in accounting issues'' (for example, Enron in 1999) would
want for its contribution. Unless the FASB can instead tax its industry
in roughly the same way that the National Association of Securities
Dealers (``NASD'') can tax the securities industry, it will remain less
than optimally independent or objective.6
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\5\ Panel on Audit Effectiveness Report at 198 (emphasis added).
\6\ In so concluding, I do not mean to attack FASB as lacking in
objectivity. On a number of issues, including the expensing of stock
options, it fought the good fight. But it has been bruised and battered
in these battles, and absent assured financing, I cannot predict that
it will be able to maintain complete objectivity.
---------------------------------------------------------------------------
Suppose financial independence is achieved. What comes next? If the
need is for a ``principle-based'' system of accounting, instead of a
``rule-based'' system (as SEC Chairman Harvey Pitt has perceptively
suggested), what principles should guide it? How should they be
drafted? Here, I think it is useful to look a little more closely at
the Enron experience. In so doing, I will necessarily be guided by the
Report, dated February 1, 2002, prepared by the Special Investigating
Committee of the Board of Directors of Enron Corp., which was chaired
by Dean William C. Powers, Jr. of the University of Texas School of Law
(the ``Powers Report''), which constitutes the most authoritative
source of information available to this point.
ii. enron's use of spes.
The Powers Report identifies a number of accounting and auditing
practices that were utilized by Enron management, possibly with the
complicity of its auditors, to manipulate its reported numbers. One
technique, however, stands out above the others: Enron's use of
numerous special-purpose entities (``SPEs''). SPEs were used by Enron
to accomplish a variety of objectives: First, because SPEs were not
consolidated onto Enron's balance sheet, they served as a vehicle for
hiding Enron's losses and enormous debts from its investors. Second,
Enron regularly sold merchant investments to these unconsolidated SPEs
and presented these transactions to the world as arm's length
transactions. Third, Enron issued stock to certain of its SPEs in
return for their notes and treated these stock issuances as if the
stock had been sold in arm's length transactions. Although all of these
uses raise serious issues, time and space considerations lead me to
focus just on the first of these: the consolidation issue.
Enron's use of SPEs was spectacular; it used hundreds of them,
often to shelter foreign-source income from U.S. taxes, but more
frequently and suspiciously, to conduct business with itself. Although
I am not an accountant, I believe that there has been a consensus among
accounting commentators that GAAP permitted Enron not to consolidate
these SPEs with its own financial statements only so long as two
conditions were satisfied: (1) independent third parties held a
``controlling'' interest in the SPE, and (2) these same parties owned a
``substantial'' interest in the SPE. Over time and without formal
action by the FASB, itself, the term ``substantial'' had come to be
understood as requiring an independent equity contribution equal to at
least 3% of the SPE's assets (the ``3% Rule'').7 Once formed
by Enron, the SPEs would then borrow debt from banks, which debt would
typically be guaranteed by Enron. Although such guarantees are not
unusual where SPEs are utilized, far less common (and indeed unique)
was the fact that the principal asset of many Enron SPEs was Enron
restricted stock. Thus, if Enron's stock price declined, the SPEs
assets would be insufficient to cover the bank debt, and Enron would
have to assume it.
---------------------------------------------------------------------------
\7\ The 3% Rule is really the product of an interpretation by the
Emerging Issues Task Force of FASB.
---------------------------------------------------------------------------
The earlier described financial restatements in late 2001 that
triggered Enron's downfall came when Arthur Andersen, as Enron's
auditor, discovered that the 3% Rule had not been complied with because
Enron had guaranteed bank loans made to Michael J. Kopper, (``Kopper'')
originally a middle level officer of Enron, to finance his stake in
Chewco, an important Enron SPE.8 Because less than the
minimum required 3% equity remained after subtraction of Kopper's
tainted stake, Chewco had to be reclassified as an Enron subsidiary,
and this disqualification had a domino-like effect, because Chewco was
the source of the outside equity in JEDI, another SPE. Hence, Chewco's
fall took JEDI with it, as neither could satisfy 3% test based on
Chewco's ownerships of JEDI. Although this discovery possibly came
late, Arthur Andersen was aware all along that Koppers was, or had
been, an Enron employee. Moreover, two other important Enron SPEs--LJM1
and LJM2--were essentially run by Andrew Fastow (``Fastow'') Enron's
chief financial officer, who served as the general partner of these
SPEs. That he could have been considered independent of Enron seems
even more debatable, because the 3% Rule requires that independent
third parties have both a ``controlling'' and ``substantial'' interest
in the SPE. Thus, even if the 3% equity test were met, the claim that
the independent parties ``controlled'' these partnerships seems
particularly tenuous when Fastow served as the general partner of both
LJM1 and LJM2. Apparently, Arthur Andersen rationalized that the two
LJM partnerships agreements sufficiently limited Fastow's authority,
because they permitted his removal by a 75% vote (later reduced to a
67% vote) of the limited partners (see Powers Report at 76), that the
limited partners (at least in Andersen's eyes) could be seen as
possessing control. Although Andersen's conclusions can be doubted, it
is perhaps more important (and certainly symptomatic) that the Powers
Report, after reviewing these transactions and Andersen's
determination, concluded: ``We have reviewed these issues in detail,
and have concluded that there are no clear answers under relevant
accounting standards.'' (Id.). Thus, even if this equivocal answer
protects Andersen, simultaneously it states the problem for Congress:
at present, there are no clear answers to these critical questions. In
their absence, gamesmanship can continue.
---------------------------------------------------------------------------
\8\ According to the Powers Report, Barclay's Bank effectively
loaned Kopper all but $125,000 of his equity investment in Chewco.
Kopper's domestic partner also owned a small fraction of the equity.
---------------------------------------------------------------------------
So what should be done to restore transparency in light of the
popularity of SPEs? Two prominent accounting scholars--Professors
George Benston and Al Hartgraves of Emory University--have argued that
an answer is already inherent in existing GAAP principles. They
conclude that FASB Statement No. 5 requires that guarantees of
indebtness, and other loss contingencies with similar characteristics,
must be disclosed even if the possibility of loss is
remote.9 The requisite disclosure should include the nature
and amount of the guarantee. Hence, they conclude that ``even if
Andersen were correct in following the letter, if not the spirit of
GAAP, in allowing Enron to not consolidate those SPEs in which
independent parties held equity equal to act at least 3% of assets,
Enron's contingent liabilities resulting from its loan guarantees
should have been disclosed and described.'' 10 If they are
correct, the guaranteed debt of SPEs must always be shown in a footnote
to the financial statements of the putative parent. Today, I seriously
doubt that most auditors are requiring such disclosure--or that most
issuers are making it.
---------------------------------------------------------------------------
\9\ See George J. Benston and Al. L. Hartgraves, ``Enron: What
Happened and What We Can Learn From It'' (forthcoming in Journal of
Accounting and Public Policy).
\10\ Id. at p. 30.
---------------------------------------------------------------------------
Thus, several important questions are now outstanding: (1) How much
discretion does an auditor possess in defining ``control'' in the case
of an SPE actively managed by a corporate official?; (2) Must the
auditor at least requre disclosure of the corporate parent's guarantee
(or other contingent obligation) with respect to SPE debts or
liabilities?; (3) Should 3% really be the measure of a ``substantial''
equity investment; (4) Should pyramid structures among SPEs be possible
so that a Chewco (assuming it had a 3% independent equity) could own 3%
of JEDI (and potentially JEDI could own 3% of still another SPE--
hypothetically R2D2)?
Press reports have suggested that FASB or its Emerging Issues Task
Force (``EITF'') may respond to Enron and the SPE issue by raising the
current 3% level of 10%. This seems precisely the kind of ``rule-
based'' approach that has no ``principled'' logic. Moreover, it also
hints at some of the procedural problems surrounding FASB. Currently,
the EITF, which was responsible for the original 3% Rule, identifies
emerging accounting issues and publishes its ``consensus'' in
authoritative releases.11 As the Panel on Audit
Effectiveness noted in its report:
---------------------------------------------------------------------------
\11\ See Panel on Audit Effectiveness at p. 198.
---------------------------------------------------------------------------
``The short time frame in which the EITF is expected to respond
to the need for guidance does not permit pre-issuance public
exposure to its pronouncements.'' 12
---------------------------------------------------------------------------
\12\ Id. at 198.
---------------------------------------------------------------------------
Such a private approach to standard-setting may have been
acceptable before Enron, but it should not be afterwards. More sunlight
is the minimum prescription for FASB in light of the arguably over-
extended earlier pronouncements of EITF in this area.
iii. what should congress do?
There are only a modest list of goals that Congress can reasonably
hope to accomplish with respect to FASB. These include:
1. Independent Financing. The costs of FASB should be spread over
all companies that file financial statements with the SEC. This cost-
spreading could be accomplished either by empowering FASB to tax its
costs on all publicly held companies or, more simply, by taxing
accounting firms that audit publicly held companies on a proportionate
basis (i.e., a firm that filed 21% of all audits would pick up 21% of
FASB's costs). Audit firms could then pass these costs along in their
audit fees (which a very concentrated market structure actually makes
more feasible).
2. Public Disclosure and SEC Consultation. The claim that the need
for quick action justifies the EITF to operate in secrecy is overbroad.
If accepted, most federal agencies could make similar claims. Public
notice and formal SEC consultation seem sound prudential procedures
that cost little and would give the SEC greater insight and possibly
leverage in the policy formulation process at FASB. In particular,
FASB's (and the EITF's) agenda should be negotiated with the SEC.
3. Principled Accounting. The ``Financial Accounting Standards
Board Act'' (the ``Act'') contemplates a more principled based system
of accounting. But how do you get there from here? The standards
specified in Section 5(a) of the Act are useful, but they omit the
critical concept that drives the U.K.'s more ``principled'' system.
U.K. GAAP requires auditors to report a ``true and fair view'' of an
enterprise's financial condition.13 Similar language could
be incorporated into Section 5(a) as a guiding instruction. Arguably,
there is already a notion of ``fair presentation'' in U.S. law, which
similarly requires the auditor to ``fairly present'' the company's
financial position (in addition to complying with U.S. GAAP), but this
can be debated (and the idea will be resisted by the industry, absent a
legislative statement).14
---------------------------------------------------------------------------
\13\ See Benston and Hartgraves, supra note 7, at 33.
\14\ The SEC's staff has recently suggested that decisions, such as
U.S. v. Simon, 425 F.2d 796 (2d Cir. 1969), do require such a fair
presentation. See Norris, ``An Old Case Is Returning to Haunt
Auditors,'' New York Times, March 1, 2002 at C-1. But unless Congress
speaks, this debate will continue indefinitely.
---------------------------------------------------------------------------
Finally, the notion of ``transparency'' is never explicitly
expressed in Section 5(a). This word may mean different things to
different people, but its omission is notable. As the Panel on Audit
Effectiveness phrased it in its recent report,
``Transparency simply means openness. It is a concept that
calls for full and fair disclosure of information to the
constituencies who need that information.'' 15
---------------------------------------------------------------------------
\15\ See Panel on Audit Effectiveness Report at p. 158.
---------------------------------------------------------------------------
It would not hurt, and it might help, if this concept were more
clearly articulated in Section 5(a) of the Act.
Mr. Stearns. I thank the gentleman.
Professor Lev.
STATEMENT OF BARUCH LEV
Mr. Lev. Thank you for the invitation.
I provided a very brief testimony, which can be added to
the record.
I read the proposed Act. I see there are several useful
elements, like the emphasis on primary standard, the focus on
intangibles, better accountability of the FASB. But on the
whole, I cannot support the Act.
The major reason is that I do not see in the Act anything
that changes the structure of the FASB, its operating
procedures, like due process, majority rule, or the governing
body. And without such changes, I do not see it is likely that
there will be any major change in accounting standard setting
in the United States after the bill is passed.
So the first question that I would like briefly to address
is: should the FASB change in a major way? And I think so. Let
me elaborate.
Institutions are usually judged by inputs and outputs, what
goes in and what comes out. On the input side, I am highly
impressed by the FASB, highly competent people, motivated,
definitely mean well, work very hard. They have issued so far
close to 200 statements, erasing single handily whole forests
in the United States.
On the output, I am somewhat less impressed. If you look at
the reporting arena, it is huge, unexplored, unchartered areas,
crucial issues that were not dealt with. Let me mention just a
few.
The first one is close to the heart of Mr. Jenkins, who is
here and for whom I have the highest respect. He led about 10
years ago a very important committee that came to be known as
the Jenkins Committee, whose major recommendation with respect
to financial reporting was that in the complex business life--
and this was 10 years ago, 12 years ago--financial measures,
measures that just reflect dollars, like sales and purchases,
are insufficient, and the system has to augmented with a whole
set of nonfinancial measures, like employee turnover and
customer dissatisfaction, a number of defective products, and
so on, and so on.
Managers wholeheartedly adopted it. Practically every
corporation now uses for internal purposes what is known as
balance score card, score card that has both financial and many
nonfinancial measures. But there was basically nothing in
financial reporting done in this area. That is the first one.
The second area, which is close to my heart, intangibles,
assets like patents and brands and information systems and
human resources, which are now, by far, the largest in size and
the major contributors of value to our corporations. Basically,
nothing has been done so far, although there is a glimmer of
hope.
In January, the FASB, last January, the FASB added some
very mild disclosure agenda items on intangibles, so the jury
is probably still out on that.
The third area, which there is basically nothing done in
financial reporting about it, is risk assessment, risk
indicators. Accounting is completely silent with respect to the
riskiness of the enterprise.
It would be incredibly important to know what would happen
to the company if interest rates change, if oil prices change,
if foreign currency change, if countries to which the companies
selling or buying from are going to be depressed. There is a
whole area of risk management, risk assessment, particularly in
finance; it did not even touch financial reporting.
And the fourth, and last one that I will mention, is a huge
area. It is one that you are very familiar with due to Enron
and others, and that is, of course, liabilities, off the
balance sheet, all kinds of promises and guarantees and other
things that are not captured by the accounting net.
As Professor Coffee mentioned, none of these issues are
new. Many of those were deliberated when I was a student, which
is a few years ago. Yet, there is no satisfactory solution, no
reporting on this issue, systematically reporting. And in many
of those cases, there is not even a progress done.
So I would really hesitate, at this stage, to Federalize
the FASB as is. Thirty years ago, at the height of discontent
with accounting standard setting, which, of course, does not
come even close to the crisis that we have now, the AICPA, the
American Institute of Certified Public Accountants, set up two
committees, which came to be known after the respective
Chairman, the Trueblood Committee, which was in charge of
determining objectives of financial reports like the rules that
the bill is talking about; and then the Francis Wheat
Committee, which was in charge of standard setting or examining
standard setting in the United States, doing an incredibly
important job.
The current FASB is the child of the Wheat Committee. This
was established exactly 30 years, in 1972. And on this
anniversary of 30 years, I propose to set an accounting
standard setting commission.
Mr. Greenwood was here and he spoke about the bill that he
initiated, the Market Integrity Commission. I think we should
do an accounting, or you, an accounting standard setting
commission to examine basically four areas, three descriptive
and one proscriptive.
The first one is to examine very carefully the 30 year
record of the FASB. I may have been overcritical, but we
definitely have to know what is the record.
The second is the role that accounting setting standard-
setting played in the current crisis and the current debacles.
People differ markedly. If you speak with accountants, for
example, practicing accountants, they will tell you that it is
the responsibility of GAAP. And many of them testified to this
effect, that they are basically chained. They are
straightjacketed by an irrelevant GAAP.
If you speak with others, it is not the responsibility of
GAAP. We should know what is the role or what was the role of
GAAP in the current crisis.
The third area that we should examine is alternative
mechanism for standard settings around the world. Professor
Dharan mentioned it, that people used to say the United States
has the best accounting framework, GAAP, in the world. I would
never have believed in that because I have never seen a shred
of evidence to support this argument, but now very few people,
I think, believe in that.
The fourth area that the commission should look into, which
of course is based on the first three, is to propose to come up
with improvement in the way accounting standards are set in the
United States.
I truly believe that once in 30 years examining accounting
standards setting is not too frequent. On the basis of this
examination, we may find ways to change the procedures, the
working, the structure, the governing bodies of FASB, and maybe
there will be a need to Federalize the FASB, but I suggest to
base it on a very close examination.
Thank you.
[The prepared statement of Baruch Lev follows:]
Prepared Statement of Baruch Lev, Stern School of Business, New York
University
I have examined carefully the proposed ``Financial Accounting
Standards Board Act.'' With all due respect, I wish to state at the
outset that I cannot support this Act.
1. reasons for lack of support
Succinctly put, I do not see how this Act will improve upon the
current state of accounting standard-setting in the U.S. The Act does
not contain any material changes to the current organizational
structure of the Financial Accounting Standards Board (FASB), nor does
it change the FASB's operating procedures (e.g., due process, or
required supermajority for new statements), or its governing bodies.
Sections 3 (Standards Authoritative) and 4 (Duty of FASB) of the Act
essentially describe the status quo. Most of Section 5 (Requirements
for Establishment of Accounting Standards) are currently included in
the FASB's Conceptual Statements.
The requirement for a Primary Standard (Section 5c) is novel and
much needed, yet it is too vague. How, for example, will the primary
standard differ from current generally accepted accounting standards?
Section 5d directs the FASB to develop standards for various important
issues, such as off balance sheet items, mark-to-market accounting, and
revenue/liabilities recognition. However, these topics have been
deliberated by the FASB for decades. What in the proposed Act will
yield an improved outcome? I, therefore, cannot support the Act.
2. my proposal:
In 1971, responding to widespread dissatisfaction with accounting
standard-setting, the American Institute of Certified Public
Accountants (AICPA) set up two important committees: One, to determine
the primary objectives of financial statements (the ``Trueblood
Committee''), and the other to study the establishment of accounting
principles (the ``Wheat Committee''). The latter--the Wheat Committee--
led to the establishment of the FASB in 1972.
Now, 30 years later, the dissatisfaction with corporate financial
reports and their audits is much more widespread and the adverse impact
on capital markets and the economy immeasurably more severe than 30
years ago. I, therefore propose to establish an Accounting Standard
Setting Commission to study: 1. The 30-year record of the FASB in
establishing accounting and financial reporting standards in the U.S.
2. The role of accounting standards in the recent cases of corporate
bankruptcies, audit failures, and financial reporting fraud. 3.
Alternative ways around the world of setting accounting standards.
With the aim of: 4. Proposing improvements in the manner by which
accounting and financial reporting standards are set in the U.S.
I strongly believe that it is crucial to condition any legislation
concerning accounting standards on a clear understanding of the FASB's
record, the role current standards played in corporate, audit, and
financial reporting failures, and the effectiveness of alternative
standard-setting mechanisms. Once in 30 years is not too frequent to
seriously study these crucial issues to investors, corporations, and
the nations' welfare.
Mr. Stearns. I thank the gentleman.
Mr. Regan.
STATEMENT OF NED REGAN
Mr. Regan. Mr. Stearns, Mr. Towns, and Members of the
Commission, thank you for inviting me.
I will make a couple of very fast points, very quick
points. One is that for 15 years, I was the New York State
Controller and had auditing and accounting responsibilities for
the City, New York City, State and local governments and
entities. The individual that preceded me was Arthur Levitt,
Senior. And the one that followed me is Carl McCone.
It is an elected position, and I have raised a lot of funds
in the course of each of those campaigns and am quite familiar
with those issues that now and then get referred to in a
different context.
I have also been a trustee of the Financial Accounting
Foundation, which oversees FASB. That has been mentioned. And
it raises the money for FASB. I can address any questions you
might have about that.
I was a member of the Volker Advisory Panel, which is now,
of course, out of business, the one that was to scrub up Arthur
Andersen, but we went out of business.
And finally, I am now the President of Baruch College. Mr.
Greenwood referred to it, and it is the Bernard Baruch College,
referred to Bernard Baruch, and it is from this background that
I speak.
We are a public college. We are publicly supported in State
and city. We are the largest business school in the country and
the second largest accountancy school in the country.
The kids that come there are from modest backgrounds. It is
the standard city college of New York story. And it is what has
been going on in New York City for over a 100 years. Poor kids
getting a break they need, and into the economy of New York,
the economy and culture of New York they go.
We probably graduate 1,000 a year. There are 2,500 a year
that get there BBA or MBA, but well over 1,000 a year are
headed for their CPAs.
I have heard Mr. Markey use a different definition of CPA,
which I suppose one could agree with, but that definition is
scary if you are thinking about 1,000 kids a year that have no
options, except to become a CPA.
And so the question that bothers me, especially with how I
feel, and I feel just like all of you feel; I share every
comment, every statement that was made and agree with it. It is
scary times. But it is scary for another reason. I do not want
our kids to join a tainted profession. And so we not just have
investors, but we have somebody else to think about.
I will give you just one example of when I was member of
the Financial Accounting Foundation, and it has not been
mentioned yet. FASB proposed about 5 years ago to put
derivative instruments or a ruling that would put derivative
instruments from the back pages of corporate financial reports,
if they even appeared there, onto the balance sheet, with a
stated value, somewhat like the stock option situation.
The business community, especially the money centered
banks, rose up and came here to Congress, and there was a lot
of lobbying and a lot of bills were authored, and fortunately
never passed. An enormous amount of pressure was put on FASB to
back off from going forward with that rule.
And one of the bills would have had FASB report every one
of its standards for a second approval to the SEC, which of
course would have put FASB right into a political context,
which, of course, was the purpose of the Bill. And the purpose
was to have us back off, like FASB backed off on stock options.
Fortunately, I came with Ed Jenkins and others, people
whose names you know and who you have met, and we spent a
couple of days here in Washington and primarily dealing with
Senator Alphonse D'Amato, who has been the chairman of the
Banking Committee, and he saw the bill right away within 5 or
10 minutes as a consumer protection bill. And of course, it
was, investor protection bill.
Under his leadership, the bill was beat back. It
disappeared. FASB went ahead with their ruling, and by the way,
it is 704 pages long. I mean, we look for clarity in the rules.
And 704 pages on a derivative standard is enormously complex.
But does anybody think a derivative is anything other than
complex? I do not know how you simply a rule that says put
derivatives on the balance sheet.
Well, on the balance sheets they went 3 years ago, and you
have not heard of them since. And you would have thought that
at the time of the scandals that we have had, where
corporations aided by their outside CPA firms, the auditing
firms, would have made use of any kind of an instrument--we
have heard some described--any kind of an instrument they
possibly could have to hide, manipulate, and engineer their
earnings.
But notice derivatives just have not appeared there. There
is no more Greenwoods gifts and greeting cards, no more Proctor
& Gamble, no more Orange Counties. I think that is a very
direct result of a FASB, very complex, very hard to discern,
but an enormous protection for consumers and for investors in
this country and it worked.
Now that experience made me, and I come from government. I
call myself now an ex-politician. I was an elected official for
over 25 years, locally and then in the state. My other
profession--and I admire what public officials, elected public
officials, do, including all the Members of Congress and all of
you.
But I get a little nervous with that, based on that
derivative experience, about moving FASB and its independence a
little closer to regulation and oversight, GAO sort of reports
and maybe increase the probability of that, as Congressman
Markey said, that there could be lobbying by Congress as to the
particular standards.
That is painful for me to say and perhaps painful for you
to hear, but that was my experience, the one experience that I
did have.
So I am nervous about that part of the bill. I endorse,
what Ed Jenkins had to say and much of what Baruch Lev and
others have had to say, about the thrust of the bill, about the
fact that somebody now in Congress is looking at accounting
standards. I think that is wonderful.
The final conclusion or remark I have has to do with
something that has been very only casually referred to, and
that is the International Accounting Standards Board. There is
a move among the industrialized countries to establish
international accounting standards, principle based, not
necessarily rule based.
Some of the issues, maybe many, perhaps all of the issues
that have been raised, both by yourselves and members of this
panel, as being as something that we desire, are conceivably
being dealt with, certainly principles versus rules based
accounting, by the International Accounting Standards Board.
And there is inevitably, and it will occur just as sure as we
are all in this room, a strong movement and inevitably the
accomplishment of international accounting standards.
So I would urge that whatever work you do here, and again,
I applaud it like my colleagues at this table, you look at the
international accounting standards movement and maybe discuss
that with the people involved-Paul Volker you have already
acknowledged in your opening statement, Mr. Chairman--as way to
cure some of the issues, maybe all of them that have been
raised.
And I fear that if we try to move ahead of them, or ahead
of this movement, we will not spook the international
accounting standards process, but I think we could raise some
problems that we really do not want to raise, especially if
they can accomplish, with your guidance and help and oversight
in hearings like today, if they can accomplish exactly the
purpose you want them to have for the American investors.
Thank you.
Mr. Stearns. I thank the witnesses, and obviously, I gave
you extra time.
I was telling the staff this feels like we are in a lecture
series hall, a very fine lecture on a very important issue, and
particularly in light of what happened today in the newspaper
with WorldCom.
The purpose we are trying to do is see if the bill that we
have proposed, that you call the draft discussion or another
term I think you used, discussion draft, is good. Now,
Professor Lev said he does not think it is. I had a feeling Dr.
Dharan does. And I think Professor Coffee seems to feel that
there is some validity to it. And Mr. Regan is cautious. Mr.
Jenkins is sort of agnostic about it. So he is being very
typical. I mean I think he is wise because of his position.
But we have gotten three ideas as just a result of your
conversations, which we think we can take adding a funding
mechanism; add Mr. Coffee's suggestion on fair representation;
and perhaps add a Commission that Professor Lev talked about in
the four things that you mentioned within the standard setting
commission, to bring that in.
So we might not all agree on our draft discussion, but you
have given us some ideas. Now Professor Coffee has said to us
that out of all the bills that has been drafted in this
subcommittee, this subcommittee of the House Commerce
Committee, is the most forward step toward trying to solve the
problem.
And so we are eager to try and do something of substance.
We are caught in a jurisdiction problem in this subcommittee
because we do not have enforcement. So we are sort of on a fine
see-saw here, which we have to work through.
But you have been very enormously helpful, and so we are
very glad to have your testimony.
Let me just ask some quick questions here.
Mr. Regan, you are on the Foundation dealing with FASB.
Mr. Regan. Right.
Mr. Stearns. Did that work? And do you think that we should
do something in the area of giving them more independence? And
how would you suggest we do that?
Mr. Regan. I think the Foundation worked in this sense,
mainly because under former SEC Chairman Levitt, he had moved
very strongly, and this is like 7 years or 8 years ago, to make
sure that there was a majority on the FAF of independent
trustees. And I was one such,and that is how I got on there.
I am not from the CPA firm.
Mr. Stearns. No, I understand that.
Mr. Regan. But it was dominated by the industry and now is
not. So the FAF and the history of that in the last 4 or 5
years has been very good.
Speaking for protecting the independence of FASB, as an FAF
trustee that myself, Emanuel Johnson, and David Reuter, former
SEC Chairman and others came to Congress on the derivatives
issue.
So I think we are covered there in a major way. And I know
there was some statement about that there is no underlying
authority for independent standard setting. I respectfully
disagree with that. I think it is an independent as it needs to
be and as it should be.
Second, it was fund raising and you did not--I raised
funds, I helped raise money for FASB. And of course, we called
on industry, and of course, that is a conflict. That is a
potential conflict. There are conflicts all over the place. It
is how you handle them that counts, and I think we handle them
well.
There were plenty of things when we would go into raise
money. We would get a little lecture sometimes, a polite
lecture about this standard or that standard, derivatives being
an example, but we managed to raise money.
These people understand that the independence of FASB is
important, that we are going to make our own or FASB is going
to make their own judgment in their way, shielded by the FAF.
Mr. Stearns. Professor Coffee, you had talked a little bit
about the gamesmanship that Enron used in dealing with the
self-dealing transaction, the special purpose entities. You
touched on the 3 percent rule.
I certainly agree with you. I guess you feel it is
ridiculously low. What would you suggest FASB do? Make it 20
percent, 10 percent?
Mr. Coffee. Well, I point in my written statement to the
written comments of George Vincent, a professor of accounting
who says that in addition to tinkering with the requisite level
in determining what is a substantial investment, you also need
to provide that when the parent organization guarantees the
debt of the special purpose entity, even though this may be a
contingent guarantee, that that should be shown on the
financial statements of the parent.
George Vincent criticizes Arthur Andersen and the whole
Enron reporting on the grounds that FASB Statement Number 5
required the inclusion in a footnote of those loss
contingencies.
I am not an accountant and I am not going to resolve this
dispute, but I think it points again to the somewhat ineffable
character here under which people interpret these rules in
different ways.
And in going forward, I think the public wants to see that
the liabilities that are guaranteed by the parent company of a
special purpose entity, because generally speaking the bank
debt of such SPE will be guaranteed by the parent, and it
should show up on the financial statements of the parent.
Mr. Stearns. So basically, you would not change the 3
percent, you would just guarantee----
Mr. Coffee. Oh, no. I would definitely think it would be
appropriate to raise that, but I think the problem here----
Mr. Stearns. It is a transparency.
Mr. Coffee. [continuing] it is not just a rule issue. It is
this principle issue. The liabilities that are guaranteed by
the parent should show on the parent's financial statement.
Mr. Stearns. So all these contingent liabilities have got
to be transparent?
Mr. Coffee. That is right.
Mr. Stearns. Yes, Professor Lev.
Mr. Lev. May I add a word here? Because that is a great
example of how you can dispose of rules and rely on principles.
I would completely dispose of any rule, 3 percent, 30 percent,
90 percent. I would rely on a principle, which is a
proportional----
Mr. Stearns. Okay. Yeah. Okay. We are going to have----
Mr. Lev. I would rely on a principle, which proportionately
consolidates the SPE with the parents. So if it is 20 percent,
then I, of course, will consolidate 80 percent, what the parent
has in this case. And then there will be a trace of the SPE in
the parent financial reports.
So you can dispose of this rule and rely on a principle of
proportional consolidation.
Mr. Stearns. Okay. My time is expired. We are going to have
a second round here. So if you will be patient. We are lucky
that we do not have any votes so that we are not interrupting
what I think is a very fascinating discussion.
The ranking member, Mr. Towns.
Mr. Towns. Thank you very much, Mr. Chairman.
Someone referred to this as being the best accounting
system in the world. I sort of missed who said that. I mean
with all the problems that we have, how could you even think
about that today?
Mr. Dharan. Representative Towns, what I said was that
others say this. It is almost mandatory now. I mean, you hear
virtually everybody who wants to say anything about the
accounting and financial reporting system say that we have the
best system in the world.
Professor Lev disagrees with it and I, personally, do not
think we have the right to claim. It is not really agree or
disagree. It is just that we need to prove through deeds, as
opposed to just making claims.
And I personally, do not think, given all the scandals we
have had and we have witnessed in the last 6 months, we have
the ability to claim that we have best financial reporting
system in the world.
We should be in a position to do that, if we clean up our
act, but right now we do not have that luxury to claim.
Mr. Towns. So you really feel that maybe it is the
resources? We do not have the necessary resources to be able to
take a very serious look at what is going on and to be able to
bring about a kind of enforcement.
I mean, what is the problem here?
Mr. Dharan. Well, I think, as I mentioned in my testimony
also, the problem is multi-folded and we really do need
multiple solutions. We have to definitely enforce the existing
rules much more clearly so that the investing public will know
that if somebody breaks the law, they will pay for it.
I think the worst thing we can ever do to any kind of law
system is when you have rules that are not viewed by the
investing public as being enforced.
We also need to take into account the needed resources of
the SEC and the FASB to address these evolving issues. As
things change in the world, we need to make new rules. There is
no question that rules need to be added over time. But are we
doing them in a way in which we are becoming too specific, as
both Professor Coffee and Lev mentioned, or are we doing it in
a way that will take care of a whole variety of evolving
problems?
I think that is where the current situation needs to be
addressed. In other words, if I see a problem somebody says,
somebody found something on the floor, and we make a new rule,
finders, keepers. Is that the way that you want to approach it
or do you want to have a general principle that says do not
take what does not belong to you?
And so, in a sense, we need to consider future evolving of
nature of these problems as opposed to just the current status
of the problems. This is exactly what the principles-based
accounting is supposed to accomplish.
Mr. Towns. Okay. Let me say, too, join my colleague, Mr.
Jenkins, in saying that it has been a pleasure working with you
over the years. And of course, I would like to get your
comments on this particular issue.
Mr. Jenkins. Well, I agree with Dr. Dharan that it is a
multifaceted issue. When we talk about what some refer to that
we have the best financial reporting system in the world, we
are talking about not only the accounting standards. We are
talking about the approach we take to auditing, the way
information is presented by management.
It is the entire scheme of things. We need to have auditors
that are independent. We need to have financial executives that
follow the intent of the principles that we provide.
Our standards are principle based. We just do not stop
there. We have had this discussion before, I think. I would be
happy to talk about principle based versus detailed later.
But it includes auditing independence, scope of service,
and accounting standards. And there is a difference between the
two, between accounting standards and auditing standards, and
we have to keep that clear in our minds as we look for a
multifaceted solution to this issue.
I believe that at the present time, the accounting
standards that we have, the standards that the FASB is
responsible for, are still the best, most comprehensive,
provide the most transparency of any set of accounting
standards in the world.
The issue, again, seems to be, for the most part, that they
have not been applied either by companies or their management,
a company's management or their auditors, apparently,in the way
that they were intended.
Some of that may well be driven by the fact of the details
that we have in our standards, and we would support moving
toward a more principle-based set of standards.
But a lot of it seems to be this corporate governance, this
tone at the top, where top management seems to have in too many
cases concluded and demonstrated to their lower management that
they can do pretty much anything that they please to excess.
And that has set a tone that perhaps has made it very easy for
those responsible internally in a company for the financial
statements to say, ``Well, if I need another penny this
quarter, it is no worse than what I see my CEO doing.''
Mr. Towns. You know, that is the part that bothers me
because it is almost at the point now where probably people are
saying everybody is cheating. If they did not cheat, you would
not be able to compete.
I mean, that is the sad commentary.
Mr. Jenkins. It is. And that is why I would--I was not
aware, Chairman Greenwood, of your proposal on your Integrity
Commission, but that seems to me, without knowing anymore about
it than what you said, that seems to me to be attacking this
issue at the right place.
Mr. Greenwood [presiding]. Thank you. The time gentlemen
has expired. I appreciate that.
The Chair recognizes himself for 5 minutes for inquiry.
To me, to get to the core of this thing, is the answer to
the following question that I would like you to answer. When we
look at an $800,000,000 restatement by Enron, when we look at
today's front page and see a $3.8 billion restatement by
WorldCom, and in between those events, all kinds of other
restatements going on, are we seeing this ability of the
accountants in cahoots with the managers of these companies to
hide losses and inflate revenues? In short, to manage earnings,
are they doing this because they are: (a) breaking and ignoring
FASB rules; (b) finding places where FASB has not gotten around
to making rules yet, and gaming the system that way, or are
they figuring out how to use FASB's rules in ways in which they
can cleverly and still deviously go to the management and say,
``Listen. Here is the FASB rule. You can use it this way and
here is how you can put the pea under the cup''? Which is it?
Mr. Jenkins.
Mr. Jenkins. Well, I think it is sort of all three. What we
do know from Enron is that they restated their financial
statements for that $1.8 million you talk about.
Mr. Greenwood. Eight hundred million.
Mr. Jenkins. Well, 800,000,000, whatever it was.
In order to get into compliance with existing standards.
We know from the Powers Report it is replete with
references to the fact that Enron either failed to comply with
existing GAAP, failed to properly structure their transactions
in order to be in compliance with GAAP.
And finally, we have the testimony in the Andersen trial
where it is clear that the advice that Andersen's professional
standards group in the national office gave to the auditors in
the field and to Enron's management simply apparently was not
followed.
Each of those three pieces of evidence would suggest that
there is nothing wrong with accounting standards. So I think,
however, I am not suggesting that we do not need to improve
accounting standards. In fact, next week, we will propose for
public comment a new standard on accounting for special purpose
entities and it will not have a bright line of 3 percent or 10
percent or whatever. It will be a principle based standard.
And we also have already proposed and have received
comments on a proposed standard dealing with disclosures of
guarantees and commitments that simply clarifies, at least from
my perspective, what we think already was in the literature.
Mr. Greenwood. Okay. Let me go right down the panel. Mr.
Dharan.
Mr. Dharan. Thank you.
I think you mentioned three things. The first one, ignoring
the rules, I do not think that is a common problem. If it is,
it is a fraud and it is a case that needs to be addressed in--
--
Mr. Greenwood. Although that is what Mr. Jenkins just said.
Mr. Dharan. I agree. But I do not think that is--I think he
mentioned about not ignoring rules as much as not doing them
the right way. That is the gray area, which is more of the
third nature, third kind that you mentioned.
They are taking the existing rules and trying to see if
they can just comply with them in the most bare minimum ways.
And that, obviously, causes questions of interpretation, and
when 2 different people come and look at it, they come up with
2 different answers.
And this is exactly why we really should not have those
kind of rules that we can go around.
But, Chairman, let me address a slightly different issue on
this, which I think you alluded to, but I want to clarify that.
The difference between what is going on now and what has
probably always been in place for 500 years in accounting is
that now the accounting violations are of a more collusive
nature, that is, involving more than just one person.
In the old days, you would read about newspaper articles
about somebody violating accounting rules or not implementing
them right, but that person, he or she would do it himself.
They may classify a cost one way versus another, and that is
being done in one room by one person or maybe a couple of
people.
What we now observe in cases like Enron and Tyco and Global
Crossing and certainly WorldCom today, these are things that
require enormous collusion and cooperative behavior between
several people of top management, the CFO, the treasurer, the
CEO, and certainly in some way indirectly or directly, the
Board of Directors.
Mr. Greenwood. With the Board of Directors either snoring
in the back room or spending so much time at the shrimp bowl
that they are not paying attention, right?
Mr. Dharan. I agree. Either they are snoring or ignoring,
but what is going on is that this is a case that involves
enormous number of people and that is why I refer to them as
financial engineering, rather than just accounting.
In order to do this, you also have lawyers and investment
banks from the outside that need to cooperate in setting up new
entities.
In the old days, we did not do that. And so, in a sense, we
are witnessing a much more comprehensive approach to financial
engineering that has been going on for the last 5 to 10 years.
Mr. Greenwood. Excellent. Thank you.
Professor Coffee.
Mr. Coffee. Let me be brief. I agree with the answer that
it is both, that there is some cheating, and that is why the
senior management of Rite Aid, the former senior management of
Rite Aid, was indicted last week for cheating in a large earned
earnings restatement case.
But there are also cases in which the rules were either
inadequate and too lax, or they were too vague and open-ended.
I think there is now getting to be agreement that the 3 percent
rule was too low. That is an example of a rule that was too
lax.
The Powers Report talks about another problem with off
balance sheet entities, and that is this question of who is
really in control. Mr. Fastow was the general partner of two of
these partnerships, LJM1 and LJM2. As a general partner, it
seems like Enron is in control of the partnership, but the
editors looked at the partnership agreement that said the
limited partners had the right to remove him with a 75 percent
vote, and they said that means he is not in control because he
could be removed.
The Powers Report says, ``We cannot figure out who is
right. These rules do not tell us what the standard is for who
is in control.''
That is rule that is a little too indefinite.
Now, a third example. We have been talking about off
balance sheet financing. Maybe the bigger problem in Enron too,
although it has not gotten as much attention, is mark to market
accounting, particularly the use of mark to market accounting
where there is no background market that gives you fair market
value.
That is an area, again, where I think accounting has a lot
of work to be done. I will defer to others who can tell me, who
know from this more, but I think there are lots of areas where
the rules are open-ended, and they can be gamed. And if you are
going to have an integrity commission, which I think is a very
useful thing, you will find that the process of gamesmanship
has become very formalized in recent years.
A major investment banking firm will come up with a new
structure, a new off balance sheet structure or new set of
relationships between SPEs and the company, and they will get
one particular accounting firm to bless it. Then they will
market this structure to every one in the industry, with a
letter saying, ``We have an accountant that will bless this. We
will give it to you. You can put it in tomorrow.''
Now, that is the process by which gamesmanship gets
marketed nationwide in a very structural way. I think that is
the kind of the process you should take a look at, but it
suggests to me that gamesmanship is there and it is not far
beneath the surface.
Mr. Greenwood. Excellent. Thank you.
Professor Lev.
Mr. Lev. I really do not have anything.
Mr. Greenwood. You have no response.
Mr. Regan.
Mr. Regan. I think, Mr. Jenkins is correct, and others,
that it is a little bit of all three. I think that I agree with
virtually everything that has been said on it.
I think that gaming the system is kind of part of life; it
is human nature. The real question, after you get through that,
Mr. Greenwood, is this. There are five points of bumps in the
road of people that should have noticed this and should have
said something about it and should have done something about.
There is the Board of Directors, and you referred to them
just now.
There are the CPA firms. We have just dealt with them.
There are the financial analysts, and thousands of them in
the country. They saw all of this happening and never told
their investors that.
There is the regulatory agencies. They had to know all of
this was going on. It was very much in the papers. They did not
do enough about.
And finally, there was the press itself that was having a
field day reporting the bubble and never lifted the rug to look
underneath it.
So there is gaming the system, and I endorse all the
suggestions, including, by the way, your market integrity
commission and added, I think, Professor Lev's additions, are
worthy of thinking about.
But its gaming is part of the process. Here are five checks
and balances, five bumps in the roads, all failed.
Mr. Greenwood. Thank you.
Mr. Shimkus [presiding]. Musical chairs.
I, too, am glad to have you. As you know, there are a
couple of hearings going on and one on the third floor on area
codes. So I am sorry that I missed a lot of the opening
statements. But I am glad to hear some of the analysis.
I have my MBA degree and one of the classes we had to take
was Ethics in Business. And I think that is a cycle that we
always have to continue to go back to, ethical, moral
principles in how we related with individuals.
People will lie, people will steal, and people will cheat.
We need the accounting profession to help us ensure that these
statements are clear.
I was interested in the mark to market comments because I
also used to be a county treasurer. It is interesting, as a
county treasurer. You have an assessed evaluation to calculate
property taxes.
Of course, the individual consumer/homeowner wants that
really low when we are evaluating property taxes, but when they
go to sell the house, they want it really, really high. And so
I always look at them in the eye, when they would come to the
point about the property tax bill, and I would say, ``Now, look
at the value that we have for your home. Would you expect to
get that much if you sold it?''
Of course, they do not want to answer the question because
it then takes the wind out of their sail.
I think that is very similar, in my casual way, of what
probably is going on with business and industry, especially
with the reorganization, and I know in our area of the country,
refineries, closures, and concentration and refineries around
the books for millions and millions of dollars. You put them up
for sale; they get half what was listed on the books.
So it is not as clear-cut as we all would like it to be.
And I do not have an answer for that.
But, Mr. Dharan, you talked about the--and this might be a
touchy question--the individual cheating or stealing versus the
collusion, which I think really has scared us and is probably
of the major concern.
I do not know if this was addressed, but do you see the
collusion? Has this occurred since we addressed the whole
accounting versus consulting debate?
Is collusion more apt to occur in this whole new era of
accounting and consulting?
Mr. Dharan. I think the collusion problem, which I referred
to as financial engineering problem, started because of the
emphasis on stock price. That started in the 1980's, primarily
thanks to stock options that were issued in large numbers
during that era. And then of course the 1990's saw an enormous
increase in stock price which led to the wealth creation that
had to be sustained.
Until the 1980's, I don't think management at the top
management level consciously sat down and did this amount of
thinking about how much to report, how do we report, where do
we get the numbers from, and so on.
Previously, you were trying to meet the sales targets, run
the company right, save the cost. But now the focus is make
sure that the market expectations are met, make sure that the--
--
Mr. Shimkus. The expectations, not necessarily the reality.
Mr. Dharan. Not necessarily the reality.
And so the game became, as President Regan mentioned, the
game became basically you set the market expectations and then
you try to meet them. But the trying to meet is where
accounting came in.
And previously, that was really done at the lower levels,
trying to make divisional profits and divisional targets, but
now we are talking about corporate profits and corporate
targets. Clearly, that meant that at the corporate level,
people had to get together and start colluding.
So rather than the CFO worrying about divisional managers
fudging numbers, now we have to worry about the CFO fudging
numbers. And this is a very different ball game, which requires
a much, much different approach to standard setting and
implementation.
Mr. Shimkus. Does anyone want to add or comment to that?
But I really find that fascinating because, in my days in
school, you would hope that the return on investment of the
productivity of a company would be enough that would affect the
stock price, not this perceived--you know, the environment, the
business environment has changed, and the new economy is a
perfect example of that wave of soaring expectations and
historic prices for very little assets, except for providing
information.
Now that industry is sorting itself out. But it is just a
new world. Where is the return on assets on an information
based environment and economy where there is no real assets
traded that you can evaluate?
So, let me ask this other.
Did anyone want to add to that?
How does Federal recognition help? It is probably addressed
in a lot of opening statements. I know the legislation gives
FASB standards Federal recognition. Why is that important?
Mr. Jenkins. Well, frankly, I am not sure that it is
important. On the one hand, it would be a statement of support
for the independence of the FASB and for the role that it plays
and its responsibilities, and that is good.
On the other hand, it raises, as there was some discussion,
the question of the interrelationship between the powers that
the SEC has through the Securities Act, the 1930 Securities
Act, and the FASB, and it seems like there would need to be
some reconciliation, if that part was to go forward.
To me, the draft legislation, as it stands, which has the
statement of giving Federal authority to the FASB, but also the
statement later on that I think says that nothing in this act
changes really the responsibilities or powers, authority of the
SEC, needs to be clarified.
Mr. Shimkus. Anyone else want to add?
My time is out. And I relinquish the chair back. Oh, he
just walked out.
Let me now recognize the ranking member for 5 minutes.
Mr. Towns. Thank you very much.
You know, the Senate bill, the Sarbanes bill, in Section
106 actually has funding. And I noticed, Professor Coffee, that
you mentioned that we are not in the position to write
technical rules and all of that, but make certain that they
have the resources.
Have any of you had the opportunity to look at the Sarbanes
bill?
Mr. Coffee. I did testify before the Sarbanes committee and
I do think there are a number of good suggestions in that bill.
Mr. Jenkins. I have looked at portions of that Bill so far
as they impact the FASB, including the funding proposal, and I
would find it an acceptable approach.
The key, Mr. Towns, is----
Mr. Towns. Hold on, just 1 second. I want to hear you. That
will go off in a second.
Okay. Now.
Mr. Jenkins. Okay. Thank you.
The key, Mr. Towns, is that if we are going to have a
nonvoluntary, stable source of funding that is going to come
from legislation, if it is going to come from legislation, we
have to be sure that it does not just change the appearance of
lack of independence or threat to independence from the
accounting profession and the business community over to
appearance of a threat of independence coming from the
political side.
And so it is important that that source of funding be clear
that it is not subject to the appropriation progress of
Congress, for example.
Sarbanes' legislation as proposed does try to do that. And
the other issue is where the funding is going to come from?
What is the source of funding?
The Sarbanes legislation, as I recall it, would have the
funding come from registrants, public companies, based on some
formula approach, and I would find that to be acceptable as
well.
Mr. Towns. Yes, Professor.
Mr. Lev. Let me say a word about funding. I mean funding
is, of course, always important, but I do not think it is
crucial in the questions that we are discussing here. Suppose,
as a mental exercise, that the FASB budget would have been
tripled tomorrow. Do you think that the outcome would have been
specifically different? I doubt it.
There are structural issues that have to be examined and
have to be resolved. And let me just give you two, very
briefly, of those.
The first one is the membership of the FASB. They are
basically all accountants. Now, I am also an accountant so I'm
not going to negatively reflect on them, but there are enormous
improvements in information in other areas which are far
distant from accounting, information systems, linguistics. In
the sciences, the DNA is the most complex information system
that exists in the universe in this case.
Now, the solutions will not come only from accountants,
only from this claustrophobic approach if we look inside and we
think that we know best this case. We have to look at outside.
We have to add members to the FASB who are not accountants in
this case and that is just one area.
The second area is that we never get rid of rules. To the
best of my knowledge, and Ed will correct me, in the entire
existence of the FASB only two statements were abolished, one
on oil and gas by the SEC and one on inflation accounting
because inflation was abated in this case.
The rules are issued without clear criteria of success, of
measuring the success, and hence, in the future there is no
ability to abolish regulation in this case. We just add and add
enormous amounts of regulation. And I am sympathetic with all
of the criticism that we have of corporate managers. I am
sympathetic with them that it becomes impossible, the
accounting burden that we have now.
There must be a process in the FASB of a continuous
examination of rules every 3, 5 years, and getting rid of those
that either do not work or are not needed anymore. These are
just two examples of structural changes in the standard setting
in the United States, and funding in my opinion is not really a
big issue here.
Mr. Towns. Interesting.
Yes, Mr. Jenkins.
Mr. Jenkins. Well, I would like to disagree a little bit
with my friend, Baruch.
First of all, while there is much more to a whole set of
information than financial reports and financial statements,
there is much to be done with respect to financial statements
alone. And I believe that if----
Mr. Towns. I am sure, Mr. Chairman, that my time is up, but
I would like to just get the answer to that question, Mr.
Chairman.
Mr. Jenkins. And I believe that if our budget were tripled
that we could put much more resources into improving our
financial statements, in our standards. I believe that we would
have time to do some of this sunset review that he suggests.
But the second point I disagree with is on that issue. We
do amend and replace standards based on new information, new
techniques. It is hard to think of a standard that we have
issued that has not amended existing literature.
And so I think to that extent we are refreshing the
literature as we go along.
Thank you.
Mr. Greenwood [presiding]. I thank my colleague.
Professor Coffee, you make an excellent point about fair
representation, that fair representation currently required by
GAAP could be interpreted to require accountants to insure that
financial statements demonstrate an accurate picture of a
company's health, even if the statements technically comply
with GAAP.
Why has the accounting industry resisted such an
interpretation?
Mr. Coffee. I think it is the pressure of litigation. This
is an open area in the law.
There was a time 30 years ago when it was clear that the
standard of looking at financial statements was whether they
gave full and fair disclosure. Under the pressure of
litigation, the certification has been narrowed a little bit,
and it talks about whether you are complying with GAAP and
whether you are giving a fair presentation in compliance with
GAAP.
All of that revising of the certificate was done in light
of lawyers advising auditors about how to reduce their
litigation profile.
During the late 1980's at least the accounting industry was
under tremendous litigation pressure and for a period of time
its viability was open to some question. Now, that has changed
dramatically with the passage of the Private Securities
Litigation Reform Act.
Mr. Greenwood. Which you had mentioned, we saw.
Professor Lev, you suggest the creation of a commission to
study failures in accounting standards. Should the commission
be appointed by the President? And who should serve on this
commission?
Mr. Lev. Definitely by the President. There is no doubt it
should be a very high level commission. And if I could just
take an example of the previous commissions, the chairman can
be a non-accountant. As far as I know, Francis Witt, and
correct me, was an SEC Commissioner previously and non-
accountant. It should have some accountants in it, but
definitely people from other areas who can speak about changes,
advances in information in this case.
Mr. Greenwood. This is my last question to Mr. Jenkins.
The revenue recognition has been under consideration for 26
of FASB's 32 years of existence, and I have made just that note
in my opening statement.
I mean, is it not time that we reach a conclusion on this
or some resolution of this issue?
Mr. Jenkins. We have now a formal project on revenue
recognition on our agenda. We will be discussing it publicly
the next time, on July 10 in our public board meeting. We are
moving forward in this area.
I think like so many things this is an area where the
progress has been made in small steps. There have been any
number of pronouncements dealing with revenue recognition over
the life of the FASB, some of them coming from the FASB, some
of them coming from other related standard setters at the
AICPA. So we have been making some progress.
But there is not a basic underlying standard in the United
States on revenue recognition, and we need one, and we are
going to have one.
Mr. Greenwood. That concludes my questions.
The ranking member.
Mr. Towns. Mr. Chairman, I guess I have more of a statement
than anything else. Being that this is very complicated and I
think we need to do something, I mean, there is no question
about it. I would like to just ask, you know, the members of
this panel to assist us in maybe making written recommendations
to us as to what they think should go into legislation.
I guess Professor Lev would not want to participate in
that, but the other members, I would like to get their opinion
on it as we move forward.
I would feel a lot more comfortable with that. It is
actually more into the technical drafting than anything else.
Mr. Greenwood. A good suggestion, a good suggestion.
I thank my colleague, and I thank all of you.
And honestly, Mr. Regan, we also believe that CPAs should
have a very secure future, and that is why here in Congress we
want to make sure that happens.
So, again, thank you for your testimony.
Mr. Regan. Thank you.
Mr. Greenwood. And I appreciate your coming.
The hearing is adjourned.
[Whereupon, at 12:28 p.m., the subcommittee was adjourned.]